##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




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Form 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO

SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934


|           |  |                                                                                                 
|---------- |  | ------------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                                 
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|          
|           |  | For the fiscal year ended December 31,
    2003                                                 
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|          
|           |  | For the transition period
    from           to           .                                     

Commission file number 001-31828

Luminent Mortgage Capital, Inc.


(Exact name of registrant as specified in its
charter)


|                                                                                                           |  |                                                   
|---------------------------------------------------------------------------------------------------------- |  | --------------------------------------------------
|Maryland(State or other jurisdiction of
    incorporation or organization)                                 |  | 06-1694835(I.R.S. Employer Identification
    No.)
|                                                                                                          
|909 Montgomery Street, Suite 500
    San Francisco, California(Address of principal executive
    offices) |  | 94133(Zip Code)                                   

Registrants telephone number, including
area code:

(415) 486-2110


Securities registered pursuant to
Section 12(b) of the Act:

|                                         |  |                                          
|---------------------------------------- |  | -----------------------------------------
|Title of Each Class                      |  | Name of Each Exchange on Which Registered
|                                         |  |                                          
|Common Stock, par value $0.001 per share |  | New York Stock Exchange                  

Securities registered pursuant to
Section 12(g) of the Act:

None


Indicate by check mark whether the registrant
(1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and
(2) has been subject to such requirements for the past
90 days.     Yes þ          No o

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be
contained, to the best of registrants knowledge, in a
definitive proxy or information statement incorporated by
reference in Part III of this Form 10-K or any
amendment to this
Form 10-K.     þ

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Act).     Yes o          No þ

The aggregate market value of the voting common
stock held by non-affiliates of the registrant as of
June 30, 2003 was $175,090,573, based on
11,406,552 shares of our common stock then held by
non-affiliates and a the price at which the common equity was
last sold on the PORTAL Market as of such date. These public
market value calculations exclude shares held on the stated
dates by our officers, directors and 5% or greater stockholders.
(Exclusion from these public market value calculations does not
imply affiliate status for any other purpose).

The number of shares of our common stock
outstanding on February 23, 2004 was 24,841,146.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our proxy statement for our 2004
Annual Meeting of Stockholders are incorporated by reference in
Items 10, 11, 12, 13 and 14 of Part III of this Annual
Report on Form 10-K. In addition, certain exhibits to our
Registration Statements on Forms S-11, as amended (nos.
333-107984 and 333-107981) and one of our Current Reports on
Form 8-K are incorporated by reference in Part IV
hereof. The Exhibit Index begins at page 89.



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INDEX

|              |  |                                                                                                                      |    |      |    | 
|------------- |  | -------------------------------------------------------------------------------------------------------------------- | -- | ---- | -- | 
|              |  |                                                                                                                      |    | Page
|              |  |                                                                                                                      |    |     
|PART I       
|Item 1.       |  | Business                                                                                                             |    |      | 3  | 
|Item 2.       |  | Properties                                                                                                           |    |      | 26 | 
|Item 3.       |  | Legal Proceedings                                                                                                    |    |      | 26 | 
|Item 4.       |  | Submission of Matters to a
    Vote of Security Holders                                                              |    |      | 26 | 
|             
|PART II      
|Item 5.       |  | Market for Registrants
    Common Equity, Related Stockholder Matters and Issuer Purchases
    of Equity Securities |    |      | 27 | 
|Item 6.       |  | Selected Financial Data                                                                                              |    |      | 31 | 
|Item 7.       |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations                            |    |      | 32 | 
|Item 7A.      |  | Quantitative and Qualitative
    Disclosures About Market Risk                                                       |    |      | 58 | 
|Item 8.       |  | Financial Statements and
    Supplementary Data                                                                      |    |      | 63 | 
|Item 9.       |  | Changes in and Disagreements
    With Accountants on Accounting and Financial Disclosure                             |    |      | 85 | 
|Item 9A.      |  | Controls and Procedures                                                                                              |    |      | 85 | 
|             
|PART III     
|Item 10.      |  | Directors and Executive
    Officers of the Registrant                                                               |    |      | 85 | 
|Item 11.      |  | Executive Compensation                                                                                               |    |      | 85 | 
|Item 12.      |  | Security Ownership of
    Certain Beneficial Owners and Management and Related Stockholder
    Matters               |    |      | 85 | 
|Item 13.      |  | Certain Relationships and
    Related Transactions                                                                   |    |      | 85 | 
|Item 14.      |  | Principal Accountant Fees
    and Services                                                                           |    |      | 85 | 
|             
|PART IV      
|Item 15.      |  | Exhibits, Financial
    Statement Schedules, and Reports on Form 8-K                                                 |    |      | 86 | 
|Signatures    |  |                                                                                                                      | 87 |     
|Exhibit Index |  |                                                                                                                      | 89 |     
|Exhibit 23.1 
|Exhibit 31.1 
|Exhibit 31.2 
|Exhibit 32.1 
|Exhibit 32.2 



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CAUTIONARY NOTE REGARDING FORWARD-LOOKING
STATEMENTS

This annual report on Form 10-K contains
certain forward-looking statements. Forward looking statements
are those which are not historical in nature. They can often be
identified by their inclusion of words such as will,
anticipate, estimate,
should, expect, believe,
intend and similar expressions. Any projection of
revenues, earnings or losses, capital expenditures,
distributions, capital structure or other financial terms is a
forward-looking statement.

Our forward-looking statements are based upon our
managements beliefs, assumptions and expectations of our
future operations and economic performance, taking into account
the information currently available to us. Forward-looking
statements involve risks and uncertainties, some of which are
not currently known to us, that might cause our actual results,
performance or financial condition to be materially different
from the expectations of future results, performance or
financial condition we express or imply in any forward-looking
statements. Some of the important factors that could cause our
actual results, performance or financial condition to differ
materially from expectations are:



| |   |                                                                                                                                                                                                                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our limited operating history and Seneca Capital
    Managements lack of experience in managing a REIT;                                                                                                                                                                                                   
|
| |  | interest rate mismatches between our
    mortgage-backed securities and our borrowings used to fund such
    purchases;                                                                                                                                                                                    
|
| |  | changes in interest rates and mortgage prepayment
    rates;                                                                                                                                                                                                                                               
|
| |  | effects of interest rate caps on our
    adjustable-rate mortgage-backed securities;                                                                                                                                                                                                                       
|
| |  | the degree to which our hedging strategies may or
    may not protect us from interest rate volatility;                                                                                                                                                                                                    
|
| |  | potential impacts of our leveraging policies on
    our net income and cash available for distribution;                                                                                                                                                                                                    
|
| |  | our ability to invest up to 10% of our investment
    portfolio in lower-credit quality mortgage-backed securities
    which carry an increased likelihood of default or rating
    downgrade relative to investment-grade securities;                                                                     
|
| |  | our boards ability to change our operating
    policies and strategies without notice to you or stockholder
    approval;                                                                                                                                                                                 
|
| |  | Seneca Capital Managements motivation to
    recommend riskier investments in an effort to maximize its
    incentive compensation under the management agreement;                                                                                                                                        
|
| |  | potential conflicts of interest arising out of
    our relationship with Seneca Capital Management, on the one
    hand, and Seneca Capital Managements relation with other
    third parties, on the other hand; and                                                                                     
|
| |  | the other important factors described in this
    annual report on Form 10-K, including those under the
    captions Managements Discussion and Analysis of
    Financial Condition and Results of Operations, Risk
    Factors, and Quantitative and Qualitative
    Disclosures about Market Risk.

We undertake no obligation to publicly update or
revise any forward-looking statements, whether as a result of
new information, future events or otherwise. In light of these
risks, uncertainties and assumptions, the events described by
our forward-looking events might not occur. We qualify any and
all of our forward-looking statements by these cautionary
factors. In addition, you should carefully review the risk
factors described in other documents we file from time to time
with the Securities and Exchange Commission, including the
Quarterly Reports on Form 10-Q to be filed by Luminent
Mortgage Capital, Inc. in 2004.

This annual report on Form 10-K contains
market data, industry statistics and other data that have been
obtained from, or compiled from, information made available by
third parties. We have not independently verified their data.

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PART I






|        |         
|------- | --------
|Item 1. | Business

Our Company

Background

We were incorporated in April 2003 to invest
primarily in U.S. agency and other highly-rated,
single-family, adjustable-rate, hybrid adjustable-rate and
fixed-rate mortgage-backed securities, which we acquire in the
secondary market. Our strategy is to acquire mortgage-related
assets, finance these purchases in the capital markets and use
leverage in order to provide an attractive return on
stockholders equity. Through this strategy, we seek to
earn income, which is generated from the spread between the
yield on our earning assets and our costs, including the
interest cost of the funds we borrow.

We commenced operations on June 11, 2003,
following the completion of a private placement of our common
stock, in which we raised net proceeds of approximately
$159.7 million. On December 18, 2003, we completed the
initial public offering of our shares of common stock and began
trading on the New York Stock Exchange, or NYSE, under the
trading symbol LUM on December 19, 2003. The initial public
offering raised approximately $170.4 million in gross
proceeds. We received the net proceeds from our initial public
offering in late December and we have used substantially all of
the net offering proceeds to purchase mortgage-backed securities
as of December 31, 2003. However, at December 31,
2003, we had not fully levered our portfolio to within our
target range of eight to 12 times the amount of our equity. As a
result, the total amount of mortgage-backed securities and
repurchase agreement liabilities as of December 31, 2003
were lower than they will be once our portfolio is fully levered
through additional repurchase agreement liabilities and related
mortgage-backed security purchases.

We are externally managed and advised by Seneca
Capital Management LLC, or the Manager, pursuant to a management
agreement, or the Management Agreement.

We expect to qualify and intend to make an
election to be taxed as a real estate investment trust, or REIT,
under the Internal Revenue Code of 1986, as amended, and as such
will routinely distribute substantially all of the income
generated from our operations to our stockholders. As long as we
retain our REIT status, we generally will not be subject to
U.S. federal or state taxes on our income to the extent
that we distribute our net income to our stockholders.

Assets

We invest primarily in adjustable-rate and hybrid
adjustable-rate mortgage-backed securities. Adjustable-rate
mortgage-backed securities have interest rates that reset
periodically, typically every six months or on an annual basis.
Hybrid adjustable-rate mortgage-backed securities have interest
rates that are fixed for the first few years of the
loan  typically three, five, seven or
10 years  and thereafter reset periodically in a
manner similar to adjustable-rate mortgage-backed securities.
See Note 3 to our financial statements included in
Item 8 of this annual report on Form 10-K for further
discussion.

We have acquired and will seek to acquire
additional assets that will produce competitive returns, taking
into consideration the amount and nature of the anticipated
returns from the investment, our ability to pledge the
investment for secured, collateralized borrowings and the costs
associated with financing, managing, securitizing and reserving
for these investments. We expect that all of the mortgage-backed
securities that we acquire will be agency-backed or have AAA
credit ratings from at least one nationally-recognized
statistical rating agency, and most of the securities will be
hybrid adjustable-rate mortgage-backed securities.

We review the credit risk associated with each
potential investment and may diversify our portfolio to avoid
undue geographic, insurer, industry and other types of
concentrations. By maintaining a large percentage of our assets
in high quality and highly-rated assets, many of which are
guaranteed under limited circumstances as to payment of a
limited amount of principal and interest by federal agencies or

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federally chartered entities such as Fannie Mae,
Freddie Mac or Ginnie Mae, we believe we can mitigate our
exposure to losses from credit risk.


We have financed our acquisition of
mortgage-backed securities by investing our equity and by
borrowing at short-term rates under repurchase agreements. We
intend to continue to finance our acquisitions in this manner.

Borrowings

We have established 17 borrowing arrangements
with various investment banking firms and other lenders, 12 of
which were in use on December 31, 2003. These borrowing
arrangements facilitated our purchase of our initial portfolio
of securities and provided us with sufficient borrowing capacity
to fully leverage the net proceeds of our initial public
offering. The repurchase agreements were secured by
mortgage-backed securities. We intend to seek to renew
repurchase agreements as they mature under the then-applicable
borrowing terms of the counterparties to our repurchase
agreements. See Note 4 to our financial statements in
Item 8 of this annual report on Form 10-K for further
discussion.

We generally seek to borrow between eight and 12
times the amount of our equity. We actively manage the
adjustment periods and the selection of the interest rate
indices of our borrowings against the adjustment periods and the
selection of indices on our mortgage-backed securities in order
to manage our liquidity and interest rate related risks.

Hedging

We may also choose to engage in various hedging
activities designed to match more closely the terms of our
assets and liabilities. At December 31, 2003, we were
engaged in short sales of Eurodollar futures contracts as a
means of mitigating our interest rate risk on forecasted
interest expense associated with the benchmark rate on
forecasted rollover/ reissuance of repurchase agreements. The
value of these futures contracts is marked-to-market daily in
our margin account with the custodian. Based upon the daily
market value of these futures contracts, we either receive funds
into, or wire funds into, our margin account with the custodian
to ensure that an appropriate margin account balance is
maintained at all times through the expiration of the contracts.
See Note 12 to the financial statements for further
discussion.

Distributions

On November 17, 2003, we paid a cash
distribution of $0.50 per share to our stockholders of
record on October 21, 2003. On January 28, 2004, we
paid a cash distribution of $0.45 per share to our
stockholders of record on December 11, 2003. Both of these
distributions are taxable dividends, and neither of these
distributions are considered return of capital. The
distributions were funded with cash flow from our ongoing
operations, including principal payments and interest payments
on our mortgage-backed securities.

Business Strategy

Our Operating Policies and Programs

Our board of directors has established the
following four primary operating policies to implement our
business strategies:



| |   |                                          
| | - | -----------------------------------------
| |  | asset acquisition policy;                
|
| |  | capital/ liquidity and leverage policies;
|
| |  | credit risk management policy; and       
|
| |  | asset/liability management policy.       

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| |                         
| | ------------------------
| | Asset Acquisition Policy

Our asset acquisition policy provides guidelines
for acquiring investments in order to maintain compliance with
our overall investment strategy. In particular, we acquire a
portfolio of investments that can be grouped into specific
categories. Each category and our respective investment
guidelines are as follows:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Category
    I At least 75% of our
    total assets will generally be residential mortgage-related
    securities and short-term investments. Assets in this category
    are rated within one of the two highest rating categories by at
    least one nationally-recognized statistical rating organization,
    or will be obligations guaranteed by federal agencies or
    federally chartered agencies, such as Fannie Mae, Freddie Mac or
    Ginnie Mae.
|
| |  | Category II
    At least 90% of our total assets will consist of Category I
    investments plus mortgage-related securities that are rated at
    least investment grade by at least one nationally-recognized
    statistical rating organization.                                                                                                                                                                                                            
|
| |  | Category III
    No more than 10% of our total assets may be of a type not
    meeting any of the above criteria. Among the types of assets
    generally assigned to this category are mortgage-related
    securities rated below investment grade and leveraged mortgage
    derivative securities, or shares of other REITs, or other
    investments.                                                                                                      

We expect to acquire only those mortgage-related
assets which we believe our manager has the necessary expertise
to evaluate and manage, which we can readily finance, and which
are consistent with our overall investment strategy and our
asset acquisition policy. Generally, we expect to hold our
mortgage-backed securities until maturity. Therefore, we
generally do not seek to acquire assets with investment returns
that are attractive only in a limited range of scenarios. Future
interest rates and mortgage prepayment rates are very difficult
to predict and, as a result, we seek to acquire mortgage-backed
securities which we believe provide acceptable returns over a
broad range of interest rate and prepayment scenarios.

We expect most of our acquisitions to consist of
adjustable-rate mortgage-backed securities, hybrid
adjustable-rate mortgage-backed securities and fixed-rate
mortgage-backed securities. We anticipate that our investments
in fixed-rate mortgage-backed securities will be focused in
shorter-term mortgages, including balloon mortgages. We may,
however, purchase longer-term fixed-rate mortgage-backed
securities if we view the potential net returns as attractive or
if the acquisition of such assets serves to reduce or diversify
the overall risk profile of our portfolio.



| |                                             
| | --------------------------------------------
| | Capital/ Liquidity and Leverage
    Policies

We employ a leverage strategy to increase our
investment assets by borrowing against existing mortgage-backed
securities and using the proceeds to acquire additional
mortgage-backed securities. We generally seek to borrow between
eight to 12 times the amount of our equity, although our
borrowings may vary from time to time depending on market
conditions and other factors deemed relevant by our manager and
our board of directors. We believe that this leaves an adequate
capital base to protect against interest rate environments in
which our borrowing costs might exceed our interest income from
mortgage-backed securities.

Depending on the different cost of borrowing
funds at different maturities, we expect to vary the maturities
of our borrowed funds to attempt to produce lower borrowing
costs. In general, our borrowings are short-term. We actively
manage, on an aggregate basis, both the interest-rate indices
and interest-rate adjustment periods of our borrowings against
the interest-rate indices and interest-rate adjustment periods
related to our mortgage-backed securities.

We expect to continue to finance our
mortgage-backed securities primarily at short-term borrowing
rates through repurchase agreements and, to a lesser extent, our
equity capital. We anticipate that, upon repayment of each
borrowing under a repurchase agreement, we will use the
collateral immediately for

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borrowing under a new repurchase agreement. In
the future we may also employ borrowings under lines of credit,
term loans and other collateralized financings that we may
establish with approved institutional lenders and we may employ
long-term borrowings.


We have established 17 borrowing arrangements
with various investment banking firms and other lenders. A
repurchase agreement, although structured as a sale and
repurchase obligation, acts as a financing under which we
effectively pledge our mortgage-backed securities as collateral
to secure a short-term loan. Generally, the other party to the
agreement makes the loan in an amount equal to a percentage of
the market value of the pledged collateral. At the maturity of
the repurchase agreement, we are required to repay the loan and
correspondingly receive back our collateral. While used as
collateral, the mortgage-backed securities continue to pay
principal and interest to us. In the event of our insolvency or
bankruptcy, certain repurchase agreements may qualify for
special treatment under the U.S. Federal Bankruptcy Code,
the effect of which, among other things, would be to allow the
creditor under the agreement to avoid the automatic stay
provisions of the U.S. Federal Bankruptcy Code and to
foreclose on the collateral agreement without delay. In the
event of the insolvency or bankruptcy of the lender during the
term of a repurchase agreement, the lender may be permitted,
under applicable insolvency laws, to repudiate the contract, and
our claim against the lender for damages may be treated simply
as an unsecured creditor. In addition, if the lender is a broker
or dealer subject to the Securities Investor Protection Act of
1970, or an insured depository institution subject to the
Federal Deposit Insurance Act, our ability to exercise our
rights to recover our securities under a repurchase agreement or
to be compensated for any damages resulting from the
lenders insolvency may be further limited by those
statutes. These claims would be subject to significant delay
and, if and when received, may be substantially less than the
damages we actually incur. As a result, we expect to enter into
collateralized borrowings only with institutions that we believe
are financially sound and which are rated investment grade by at
least one nationally-recognized statistical rating organization.

Substantially all of our borrowing agreements
require us to deposit additional collateral in the event the
market value of existing collateral declines, which may require
us to sell assets to reduce our borrowings. We have designed our
liquidity management policy to maintain an adequate capital base
sufficient to provide required liquidity to respond to the
effects under our borrowing arrangements of interest rate
movements and changes in the market value of our mortgage-backed
securities, as described above. However, a major disruption in
the repurchase or other market that we rely on for short-term
borrowings would harm our results of operations unless we were
able to arrange alternative sources of financing on comparable
terms.



| |                              
| | -----------------------------
| | Credit Risk Management Policy

We review credit risk associated with each of our
potential investments. In addition, we may diversify our
portfolio of mortgage-backed securities to avoid undue
geographic, insurer, industry and certain other types of
concentration risk. We may reduce risk from sellers and
servicers by obtaining representations and warranties. Our
manager monitors the overall portfolio risk in order to
determine appropriate levels of provision for losses we may
experience.

We generally determine, at the time of purchase,
whether or not a mortgage-related asset complies with our credit
risk management policy guidelines, based upon the most recent
information utilized by us. Such compliance is not expected to
be affected by events subsequent to such purchase, such as
changes in characterization, value or rating of any specific
mortgage-related assets or economic conditions or events
generally affecting any mortgage-related assets of the type held
by us.



| |                                       
| | --------------------------------------
| | Asset/ Liability Management
    Policy

Interest Rate Risk
Management.To the extent consistent
with our election to qualify as a REIT, we follow an interest
rate risk management program intended to protect our portfolio
of mortgage-backed securities and related debt against the
effects of major interest rate changes. Specifically, our
interest rate management program is formulated with the intent
to offset, to some extent, the potential adverse effects

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resulting from rate adjustment limitations on our
mortgage-backed securities and the differences between interest
rate adjustment indices and interest rate adjustment periods of
our adjustable-rate mortgage-backed securities and related
borrowings.


Our interest rate risk management program
encompasses a number of procedures, including the following:



| |   |                                                                                                                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | monitoring and adjusting, if necessary, the
    interest rate sensitivity of our mortgage-backed securities
    compared with the interest rate sensitivities of our borrowings;                                                                                                         
|
| |  | attempting to structure our borrowing agreements
    to have a range of different maturities and interest rate
    adjustment periods (although substantially all will be less than
    one year); and                                                                                   
|
| |  | actively managing, on an aggregate basis, the
    interest rate indices, interest rate adjustment periods, and
    gross reset margins of the mortgages underlying our
    mortgage-backed securities compared to the interest rate indices
    and adjustment periods of our borrowings.

As a result, we expect to be able to adjust the
average maturity/ adjustment period of our borrowings on an
ongoing basis by changing the mix of maturities and interest
rate adjustment periods as borrowings mature or are renewed.
Through the use of these procedures, we attempt to reduce the
risk of differences between interest rate adjustment periods of
the mortgages underlying our adjustable-rate mortgage-backed
securities and our related borrowings.

It is generally our intention to manage the
assets in our portfolio with regard to risk characteristics such
as duration, in order to carefully limit the overall interest
rate risk of the portfolio. On occasion, we may alter the
overall duration in order to better protect the portfolio in
order to protect shareholder value. Similarly, it is our
intention to manage the duration of our liabilities. Generally,
we will seek to reduce the gap between the duration of our
assets and our liabilities to a level which is consistent with
protection of the portfolio during volatile interest rate
environments. The means by which we will accomplish this
objective will vary over time, and may include the use of
hedging instruments and the alteration of the duration of the
asset and/or the liability side of our balance sheet through
asset purchases or sales and through the assumption or the
retirement of repurchase agreements of varying maturities or the
structuring of other financing arrangements.

Depending on market conditions and the cost of
the transactions, we may conduct hedging activities in
connection with our portfolio management. When we engage in
hedging activities, we intend to do so in a manner consistent
with our election to qualify as a REIT. The goal of any hedging
strategy we adopt will be to lessen the effects of interest rate
changes and to enable us to earn net interest income in periods
of generally rising, as well as declining or static, interest
rates. Specifically, if we implement a hedging program, it would
likely be formulated with the intent to offset some of the
potential adverse effects of changes in interest rate levels
relative to the interest rates on the mortgage-backed securities
held in our investment portfolio, as well as differences between
the interest rate adjustment indices and maturity or reset
periods related to our mortgage-backed securities and our
borrowings.

Under the REIT rules of the Internal Revenue
Code, some hedging activities produce income which is not
qualifying income for purposes of the REIT gross income tests or
create assets which are not qualifying assets for purposes of
the REIT assets test. As a result, we may have to terminate
certain hedging activities before the benefits of such
activities are realized. In the case of excess hedging income,
we would be required to pay a penalty tax for failure to satisfy
certain REIT income tests under the Internal Revenue Code if the
excess is due to reasonable cause and not willful neglect. In
the case of having excess value in relation to mortgage-related
assets, the penalty would result in our disqualification as a
REIT. In addition, asset/liability management involves
transaction costs that increase dramatically as the period
covered by hedging protection increases and that may increase
during periods of fluctuating interest rates.

Prepayment Risk
Management.We also seek to lessen the
effects of prepayment of mortgage loans underlying our
securities at a faster or slower rate than anticipated. We
expect to accomplish this by using

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a variety of techniques which include, without
limitation, structuring a diversified portfolio with a variety
of prepayment characteristics, investing in mortgage-backed
securities based on mortgage loans with prepayment prohibitions
and penalties, investing in certain mortgage security structures
that have prepayment protections, and purchasing mortgage-backed
securities at a premium and at a discount. We intend to monitor
prepayment risk through the periodic review of the impact of a
variety of prepayment scenarios on our revenues, net earnings,
distributions, cash flow and net balance sheet market value.


We believe that we have developed cost-effective
asset/liability management policies to mitigate interest rate
and prepayment risks. We continually monitor our risk management
strategies as market conditions change. However, no strategy can
completely insulate us from interest rate and prepayment risks.
Further, as noted above, certain of the U.S. federal income
tax requirements that we must satisfy to qualify as a REIT limit
our ability to fully hedge our interest rate and prepayment
risks. Therefore, we could be prevented from effectively hedging
our interest rate and prepayment risks.

Description of Mortgage-Related
Assets



| |                           
| | --------------------------
| | Mortgage-Backed Securities

Pass-Through
Certificates.We expect principally to
invest in pass-through certificates, which are securities
representing interests in pools of mortgage loans secured by
residential real property in which payments of both interest and
principal on the securities are generally made monthly. In
effect, these securities pass through the monthly payments made
by the individual borrowers on the mortgage loans that underlie
the securities, net of fees paid to the issuer or guarantor of
the securities. Pass-through certificates can be divided into
various categories based on the characteristics of the
underlying mortgages, such as the term or whether the interest
rate is fixed or variable.

A key feature of most mortgage loans is the
ability of the borrower to repay principal earlier than
scheduled. This is called a prepayment. Prepayments can arise
due to sale of the underlying property, refinancing,
foreclosure, or other events. Prepayments result in a return of
principal to pass-through certificate holders. This may result
in a lower or higher rate of return upon reinvestment of
principal. This is generally referred to as prepayment
uncertainty. If a security purchased at a premium pre-pays at a
higher than expected rate, then the value of the premium would
be eroded at a faster than expected rate. Similarly, if a
discount mortgage pre-pays at a lower than expected rate, the
amortization towards par would be accumulated at a slower than
expected rate. The possibility of these undesirable effects is
sometimes referred to as prepayment risk.

In general, but not always, declining interest
rates tend to increase prepayments, and rising interest rates
tend to slow prepayments. Like other fixed-income securities,
when interest rates rise, the value of mortgage-backed
securities generally decline. The rate of prepayments on
underlying mortgages will affect the price and volatility of
mortgage-backed securities and may have the effect of shortening
or extending the effective maturity of the security beyond what
was anticipated at the time of purchase. If interest rates rise,
our holdings of mortgage-backed securities may experience
reduced returns if the borrowers of the underlying mortgages pay
off their mortgages later than anticipated. This is generally
referred to as extension risk.

Payment of limited amounts of principal and
interest on some mortgage pass-through securities, although not
the market value of the securities themselves, may be guaranteed
by the full faith and credit of the federal government,
including securities backed by Ginnie Mae, or by agencies or
instrumentalities of the federal government, including Fannie
Mae or Freddie Mac. Mortgage-backed securities created by
non-governmental issuers, including commercial banks, savings
and loan institutions, private mortgage insurance companies,
mortgage bankers and other secondary market issuers, may be
supported by various forms of insurance or guarantees, including
individual loan, title, pool and hazard insurance and letters of
credit, which may be issued by governmental entities, private
insurers or the mortgage poolers.

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The mortgage loans underlying pass-through
certificates can generally be classified in the following four
categories:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Adjustable-Rate
    Mortgages.Adjustable-rate mortgages,
    or ARMs, are those for which the borrower pays an interest rate
    that varies over the term of the loan. The interest rate usually
    resets based on market interest rates, although the adjustment
    of such an interest rate may be subject to certain limitations.
    Traditionally, interest rate resets occur at regular set
    intervals (for example, once per year). We will refer to such
    ARMs as traditional ARMs. Because the interest rates
    on ARMs fluctuate based on market conditions, ARMs tend to have
    interest rates that do not deviate from current market rates by
    a large amount. This in turn can mean that ARMs have less price
    sensitivity to interest rates. This may be attractive to some
    mortgage investors.                                                                                                                                                                                                                                                                          
|
| |  | Fixed-Rate
    Mortgages.Fixed-rate mortgages are
    those where the borrower pays an interest rate that is constant
    throughout the term of the loan. Traditionally, most fixed-rate
    mortgages have an original term of 30 years. However,
    shorter terms (also referred to as final maturity dates) have
    become common in recent years. Because the interest rate on the
    loan never changes, even when market interest rates change, over
    time there can be a divergence between the interest rate on the
    loan and current market interest rates. This in turn can make a
    fixed-rate mortgages price sensitive to market
    fluctuations in interest rates. In general, the longer the
    remaining term on the mortgage loan, the greater the price
    sensitivity. One way to attempt to lower the price sensitivity
    of a portfolio of fixed-rate mortgages is to buy those with
    shorter remaining terms or maturities.                                                                                                                                            
|
| |  | Hybrid Adjustable-Rate
    Mortgages.A recent development in the
    mortgage market has been the popularity of ARMs that do not
    reset at regular intervals. Many of these ARMs have a fixed-rate
    for the first few years of the loan  typically three,
    five, seven or 10 years  and thereafter reset
    periodically like a traditional ARM. Effectively such mortgages
    are hybrids, combining the features of a pure fixed-rate
    mortgage and a traditional ARM. Hybrid ARMs have a
    price sensitivity to interest rates similar to that of a
    fixed-rate mortgage during the period when the interest rate is
    fixed and similar to that of an ARM when the interest rate is in
    its periodic reset stage. However, because many hybrid ARMs are
    structured with a relatively short initial time span during
    which the interest rate is fixed, even during that segment of
    its existence, the price sensitivity may be low. The ability of
    hybrid ARMs to exhibit low price sensitivity to interest rates
    can be attractive to some mortgage investors.
|
| |  | Balloon Maturity
    Mortgages.Balloon maturity mortgages
    are a type of fixed-rate mortgage. Thus, they have a static
    interest rate for the life of the loan. However the term of the
    loan is usually quite short and is less than the amortization
    schedule of the loan. Typically, this term or maturity is less
    than seven years. When the mortgage matures, the investor
    receives all of his principal back. This is effectively a price
    reset of the invested principal to par. As the balloon maturity
    mortgage approaches its maturity date, the price sensitivity of
    the mortgage declines. In fact, the price sensitivity for an
    agency balloon mortgage with a set maturity is actually lower
    than that for an agency hybrid ARM with the same time to
    interest rate reset. The ability of a balloon mortgage to have
    low price sensitivity to interest rates can be attractive for
    some mortgage investors.                                                                                                                                    

Collateralized Mortgage
Obligations.Collateralized mortgage
obligations, or CMOs, are a type of mortgage-backed security.
Interest and principal on a CMO are paid, in most cases, on a
monthly basis. CMOs may be collateralized by whole mortgage
loans, but are more typically collateralized by portfolios of
mortgage pass-through securities guaranteed by Fannie Mae,
Freddie Mac or Ginnie Mae. CMOs are structured into multiple
classes, or tranches, with each class bearing a different stated
maturity. Monthly payments of principal, including prepayments,
are first returned to investors holding the shortest maturity
class; investors holding the longer maturity classes receive
principal only after the first class has been retired.

Generally, fixed-rate mortgages are used to
collateralize CMOs. However, the CMO tranches need not all have
fixed-rate coupons. Some CMO tranches have floating rate coupons
that adjust based on market interest rates, subject to some
limitations. Such tranches, often called CMO
floaters, can have

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relatively low price sensitivity. As is the case
with traditional ARMs, hybrid ARMs and balloons, this low price
sensitivity may be attractive to some mortgage investors.


Mortgage Derivative
Securities.Although we do not have
any intention to do so in the near term, we may acquire mortgage
derivative securities in an amount not to exceed 10% of our
total assets. Mortgage derivative securities allow the holder to
receive interest only, principal only, or interest and principal
in amounts that are disproportionate to those payable on the
underlying mortgage loans. Payments on mortgage derivative
securities can be highly sensitive to the rate of prepayments on
the underlying mortgage loans. In the event of faster or slower
than anticipated prepayments on these mortgage loans, the rates
of return on interests in mortgage derivative securities
representing the right to receive interest only or a
disproportionately large amount of interest, or interest only
derivatives, would be likely to decline or increase,
respectively. Conversely, the rates of return on mortgage
derivative securities representing the right to receive
principal only or a disproportionate amount of principal, or
principal only derivatives, would be likely to increase or
decrease in the event of faster or slower prepayment speeds,
respectively.

We may also invest in inverse floaters, a class
of CMOs with a coupon rate that resets in the opposite direction
from the market rate of interest to which it is indexed,
including LIBOR or the 11th District Cost of Funds Index, or
COFI. Any rise in the index rate, which can be caused by an
increase in interest rates, causes a drop in the coupon rate of
an inverse floater while any drop in the index rate causes an
increase in the coupon of an inverse floater. An inverse floater
may behave like a leveraged security since its interest rate
usually varies by a magnitude much greater than the magnitude of
the index rate of interest. The leverage-like characteristics
inherent in inverse floaters are associated with greater
volatility in their market prices.

We may also invest in other mortgage derivative
securities that may be developed in the future.

Subordinated
Interests.We may also acquire
subordinated interests, which are classes of mortgage-backed
securities that are junior to other classes of the same series
of mortgage-backed securities in the right to receive payments
from the underlying mortgage loans. The subordination may be for
all payment failures on the mortgage loans securing or
underlying such series of mortgage securities. The subordination
will not be limited to those resulting from particular types of
risks, including those resulting from war, earthquake or flood,
or the bankruptcy of a borrower. The subordination may be for
the entire amount of the series of mortgage-related securities
or may be limited in amount.



| |               
| | --------------
| | Mortgage Loans

We may acquire and accumulate mortgage loans
(i.e., fixed-rate, ARMs, hybrid and balloon mortgage loans) as
part of our investment strategy until a sufficient quantity has
been accumulated for securitization into high-quality
mortgage-backed securities in order to enhance their value and
liquidity. Pursuant to our asset acquisition policies, the
aggregate amount of any mortgage loans that we acquire and do
not immediately securitize, together with our investments in
other mortgage-related assets that are not Category I or
Category II assets, will not constitute more than 10% of
our total assets at any time. All mortgage loans, if any, will
be acquired with the intention of securitizing them into
high-credit quality mortgage securities. Despite our intentions,
however, we may not be successful in securitizing these mortgage
loans. To meet our investment criteria, mortgage loans acquired
by us will generally conform to the underwriting guidelines
established by Fannie Mae, Freddie Mac, Ginnie Mae or other
credit insurers. Applicable banking laws generally require that
an appraisal be obtained in connection with the original
issuance of mortgage loans by the lending institution. We do not
intend to obtain additional appraisals at the time of acquiring
any mortgage loans.

Mortgage loans may be originated by or purchased
from various suppliers of mortgage-related assets throughout the
United States, including savings and loans associations, banks,
mortgage bankers and other mortgage lenders. We may acquire
mortgage loans directly from originators and from entities
holding mortgage loans originated by others. Our board of
directors has not established any limits upon the geographic
concentration of mortgage loans that we may acquire. However,
our asset acquisition policy will limit the amount and/or type
of mortgage loans we may acquire.

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| |                  
| | -----------------
| | Other Investments

We may acquire other investments that include
equity and debt securities issued primarily by other
mortgage-related finance companies, interests in
mortgage-related collateralized bond obligations, other
subordinated interests in pools of mortgage-related assets,
commercial mortgage loans and securities, and residential
mortgage loans other than high-credit quality mortgage loans.
These investments are generally considered Category III
investments under our asset acquisition policy and shall be
limited to 10% of our total assets.

We also intend to operate in a manner that will
not subject us to regulation under the Investment Company Act.
Our board of directors has the authority to modify or waive our
current operating policies and our strategies without prior
notice to you and without stockholder approval.

Investment Strategy

Our strategy is to invest primarily in
U.S. agency and other highly-rated single-family
adjustable-rate and fixed-rate mortgage-backed securities. We
acquire these investments in the secondary market and seek to
acquire assets that will produce competitive returns after
considering the amount and nature of the anticipated returns
from the investment, our ability to pledge the investment for
secured, collateralized borrowings and the costs associated with
financing, managing, securitizing and reserving for these
investments. We do not construct our overall investment
portfolio in order to express a directional expectation for
interest rates or mortgage prepayment rates. Future interest
rates and mortgage prepayment rates are very difficult to
predict and, as a result, we seek to acquire mortgage-backed
securities which we believe provide acceptable returns over a
broad range of interest rate and prepayment scenarios. When
evaluating the purchase of mortgage-backed securities, we
analyze whether the purchase will permit us to continue to
satisfy the minimum 55% portfolio whole-pool requirement, with
which we must comply to maintain our REIT status. We also assess
the relative value of the mortgage-backed security and how well
it would fit into our existing portfolio of mortgage-backed
securities. Many aspects of a mortgage-backed security, and the
dynamic interaction of its characteristics with those of our
portfolio, can influence our perception of what that security is
worth and the amount of premium we would be willing to pay to
own the specific security. The characteristics of each potential
investment we analyze generally include, but are not limited to,
the following:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | origination
    year the underwriting year
    for the mortgages comprising the mortgage-backed security. This
    characteristic helps to determine how seasoned the
    mortgage-backed security is and can influence our expectations
    for the investments future cash flows. In the current low
    interest rate environment, mortgages that were originated
    several years ago (when interest rates were higher) tend to have
    been refinanced. Those borrowers who did not refinance their
    homes during the period of lower interest rates may be
    relatively less likely (than more recent borrowers) to refinance
    during the remaining life of their mortgages. Therefore, the
    expected cash flows from a potential investment with an earlier
    origination year could exhibit less sensitivity to changes in
    interest rates.                                                                                                                                                                                                                                                                                                     
|
| |  | originator
    the financial services entity that underwrites the mortgages
    comprising the mortgage-backed security. Originators do not have
    homogeneous underwriting standards. The particular underwriting
    standards utilized by an originator tend to influence the
    characteristics of the borrowers in its mortgage loan pools
    which, in turn, can influence the pools prepayment rates
    and other cash flows. When analyzing a pool of mortgages, it can
    be useful to review the historical cash flows exhibited by the
    originators prior mortgage loan pools. For example, we may
    limit the premium we would be willing to pay for a security if
    the originator has a history of early refinancings. The quality
    of the originators underwriting standards and the terms it
    offers borrowers can also be important to our purchase
    decisions. These variables potentially include the
    originators required loan documentation, FICO scores,
    loan-to-value ratios, prepayment penalties, cap rates, and
    assumability terms. Any of these variables might influence our
    expectations regarding the

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | timing of cash flows from an originators
    mortgage-backed securities and, thus, their attractiveness for
    our portfolio.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|
| |  | coupon
    the weighted-average mortgage coupon of the mortgage-backed
    security. Higher coupons are initially attractive because they
    can generate more interest income for us than lower-coupon
    mortgage-backed securities. However, the sustainability of cash
    flows from higher-coupon pools is less predictable because, all
    else being equal, higher-coupon mortgages have a greater
    probability of being refinanced than lower-coupon mortgages. We
    generally analyze a mortgage-backed securitys coupon in
    comparison to current market rates to form an expectation
    regarding how sustainable the interest income from the
    investment will be.                                                                                                                                                                                                                                               
|
| |  | margin
    the spread between an adjustable-rate mortgages market
    index and the interest rate that the borrower must pay to
    service the mortgage. Similar to higher coupons, higher margins
    are attractive because they can generate more interest income
    for us than lower-margin mortgage-backed securities. However,
    higher-margin mortgage pools may be more prone to experience
    faster refinancing rates because high-margin borrowers are
    relatively more likely to find opportunities to refinance into
    mortgages with lower spreads to the index. As a result, the
    sustainability of the yield from an investment in a high-margin
    mortgage pool is less certain and the premium we would be
    willing to pay on such an investment, all else being equal, is
    less.                                                                                                                    
|
| |  | periodic
    cap the amount by which
    the interest rate on an adjustable-rate mortgage can adjust
    during a specified period, usually six or 12 months. In
    rapidly rising interest rate environments, higher periodic caps
    are more attractive because they reduce the risk of the
    adjustable-rate mortgage coupon not being able to reset fully
    upwards to the current market rate. Conversely, in rapidly
    falling interest rate environments, lower periodic caps increase
    the probability that the mortgages coupon will reset to a
    level that remains above the current market rate.                                                                                                                                                                                                                                                                                                                   
|
| |  | lifetime
    cap the maximum interest
    rate that a specific adjustable-rate mortgage can have during
    its lifetime. The lifetime cap of a mortgage is often correlated
    with market interest rates at the time of origination. An
    adjustable-rate mortgage originated in a low interest rate
    environment frequently will have a lower lifetime cap than a
    comparably structured mortgage originated in a high interest
    rate environment. If interest rates rise sufficiently, an
    adjustable-rate mortgage with a lifetime cap can effectively
    behave like a fixed-rate mortgage because the coupon of the
    adjustable-rate mortgage cannot adjust above the lifetime cap,
    and will thus remain effectively fixed at that level until rates
    fall. Higher lifetime caps tend to make particularly structured
    hybrid or adjustable-rate mortgage pools more attractive
    investment candidates.
|
| |  | time-to-reset
    the number of months before the current coupon of the hybrid or
    adjustable-rate mortgage will reset. Time-to-reset is an
    important consideration as we structure the timing of interest
    rate adjustments on the mortgage-backed securities in our
    portfolio relative to changes in our borrowing costs.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| |  | loan-to-value
    the ratio between the original loan amount and the value of the
    collateral securing the mortgage loan. We consider this factor
    less important in a decision to purchase agency-backed mortgage
    securities but it can be an important factor when purchasing
    non-agency securities. This factor also influences the
    subordination levels required by the national rating agencies to
    receive AAA-rated status.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|
| |  | geographic
    dispersion the degree to
    which the properties underlying the pooled mortgage loans are
    geographically dispersed. We prefer greater geographic
    dispersion because we wish to limit our exposure to specific
    states or regions (which might be experiencing relatively
    greater economic difficulties) to create a more stable portfolio.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| |  | price and prepayment
    expectations the expected
    yield of the mortgage-backed security under various assumptions
    about future economic conditions. A mortgage-backed
    securitys ultimate yield is determined by its price and
    its actual prepayment levels. We generally form expectations,
    based on the above factors, regarding how the mortgage
    pools prepayment levels will change over time,                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

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| |  |                                                                                                                                                                                                                                                                                                                
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | including in response to possible changes in
    prevailing interest rates and other economic conditions, so as
    to determine whether its offered price creates a yield that is
    attractive and fits well with the expected structure of our
    portfolio and our borrowing costs under those scenarios.

We generally consider these factors when
evaluating an investments relative value and the impact it
would likely have on our overall portfolio. We do not assign a
particular weight to any factor because the relative importance
of the various factors varies, depending upon the
characteristics we seek for our portfolio and our borrowing cost
structure.

We do not currently originate mortgage loans or
provide other types of financing to the owners of real estate
and we do not service any mortgage loans. However, in the
future, we may elect to originate mortgage loans or other types
of financing, and we may elect to service mortgage loans and
other types of financing.

Financing Strategy

We expect to finance the acquisition of our
mortgage-backed securities with short-term borrowings and term
loans with a term of less than one year and, to a lesser extent,
equity capital. After analyzing the then-applicable interest
rate yield curves, we may finance with long-term borrowings from
time to time. The amount of borrowing we employ depends on,
among other factors, the amount of our equity capital. We expect
to use leverage to attempt to increase potential returns to our
stockholders. Pursuant to our capital and leverage policy, we
seek to strike a balance between the under-utilization of
leverage, which reduces potential returns to our stockholders,
and the over-utilization of leverage, which increases risk by
reducing our ability to meet our obligations to creditors during
adverse market conditions.

We expect to borrow at short-term rates using
repurchase agreements. Repurchase agreements are generally
short-term in nature. We intend to actively manage the
adjustment periods and the selection of the interest rate
indices of our borrowings against the adjustment periods and the
selection of indices on our mortgage-backed securities in order
to limit our liquidity and interest rate related risks. We
generally seek to diversify our exposure by entering into
repurchase agreements with multiple lenders. In addition, we
expect to enter into repurchase agreements only with
institutions we believe are financially sound and which meet
credit standards approved by our board of directors.

Industry Trends

We believe fundamental changes are occurring in
the U.S. mortgage market, resulting in the shifting of
investment capital and mortgage-related assets out of
traditional lending and savings institutions and into new forms
of mortgage banking and mortgage investment firms, including
those that qualify as REITs under the Internal Revenue Code. We
believe that traditional mortgage investment companies, such as
banks, thrifts and insurance companies, provide less attractive
investment structures for investing in mortgage-related assets
because of the costs associated with regulation, infrastructure
and corporate level taxation. As a REIT, we can generally pass
through earnings to our stockholders without incurring an
entity-level federal income tax, thereby allowing us to make
higher distributions than institutions with similar investments
that are subject to federal income tax on their earnings.
Additionally, with the development of highly competitive
national mortgage markets (which we believe is partly due to the
expansion of government sponsored enterprises such as Fannie
Mae, Freddie Mac and Ginnie Mae), local and regional mortgage
originators have lost market share to more efficient mortgage
originators who compete nationally. The growth of the secondary
mortgage market, including new securitization techniques, has
also resulted in financing structures that can be utilized
efficiently to fund leveraged mortgage portfolios and better
manage interest rate risk.

The U.S. residential mortgage market has
experienced considerable growth over the past 11 years,
with total outstanding U.S. residential mortgage debt
growing from approximately $3.0 trillion in 1992 to
approximately $7.1 trillion as of September 30, 2003,
according to the Federal Reserve. According to the same source,
the total amount of U.S. residential mortgage debt
securitized into mortgage-backed securities has grown from
approximately $1.4 trillion in 1992 to approximately
$4.1 trillion as of

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September 30, 2003, approximately
$3.3 trillion of which was agency-backed and therefore
generally consistent with our investment guidelines. As of
September 30, 2003, approximately $47.2 billion of the
available mortgage-backed securities was held by REITs.


Competition

When we invest in mortgage-backed securities and
other investment assets, we compete with a variety of
institutional investors, including other REITs, insurance
companies, mutual funds, hedge funds, pension funds, investment
banking firms, banks and other financial institutions that
invest in the same types of assets. Many of these investors have
greater financial resources and access to lower costs of capital
than we do. The existence of these competitive entities, as well
as the possibility of additional entities forming in the future,
may increase the competition for the acquisition of
mortgage-backed securities, resulting in higher prices and lower
yields on assets.

Certain Federal Income Tax
Considerations

The following discussion summarizes the material
U.S. federal income tax considerations regarding our
qualification and taxation as a REIT and the material
U.S. federal income tax consequences resulting from the
acquisition, ownership and disposition of our common stock. The
following discussion is not exhaustive of all possible tax
considerations. This summary neither gives a detailed discussion
of any state, local or foreign tax considerations nor discusses
all of the aspects of U.S. federal income taxation that may
be relevant to you in light of your particular circumstances or
to particular types of stockholders which are subject to special
tax rules, such as insurance companies, tax-exempt entities,
financial institutions or broker-dealers, foreign corporations
or partnerships, and persons who are not citizens or residents
of the United States, stockholders that hold our stock as a
hedge, part of a straddle, conversion transaction or other
arrangement involving more than one position, or stockholders
whose functional currency is not the U.S. dollar. This
discussion assumes that you will hold our common stock as a
capital asset, generally property held for
investment, under the Internal Revenue Code.

You are urged to consult with your own tax
advisor regarding the specific consequences to you of the
purchase, ownership and sale of stock in an entity electing to
be taxed as a REIT, including the federal, state, local, foreign
and other tax considerations of such purchase, ownership, sale
and election and the potential changes in applicable tax laws.

General

We intend to make an election to be taxed as a
REIT under the Internal Revenue Code commencing with our taxable
year ending December 31, 2003. Our qualification and
taxation as a REIT depend on our ability to meet, through actual
annual operating results, distribution levels, diversity of
stock ownership, and the various other qualification tests
imposed under the Internal Revenue Code discussed below. No
assurance can be given that our actual results for any
particular taxable year will satisfy these requirements. See
 Failure to Qualify as a REIT. In
addition, qualification as a REIT depends on future transactions
and events that cannot be known at this time.

So long as we qualify for taxation as a REIT, we
generally will be permitted a deduction for dividends we pay to
our stockholders. As a result, we generally will not be required
to pay federal corporate income taxes on our net income that is
currently distributed to our stockholders. This treatment
substantially eliminates the double taxation that
ordinarily results from investment in a corporation. Double
taxation means taxation once at the corporate level when income
is earned and once again at the stockholder level when this
income is distributed. We will be required to pay
U.S. federal income tax, however, as follows:



| |   |                                                                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | we will be required to pay tax at regular
    corporate rates on any undistributed REIT taxable net income,
    including undistributed net capital gain;
|
| |  | we may be required to pay the alternative
    minimum tax on our items of tax preference; and                                                          

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | if we have (1) net income from the sale or
    other disposition of foreclosure property which is
    held primarily for sale to customers in the ordinary course of
    business or (2) other non-qualifying income from
    foreclosure property, we will be required to pay tax at the
    highest corporate rate on this income. Foreclosure property is
    generally defined as property acquired through foreclosure or
    after a default on a loan secured by the property or on a lease
    of the property.

We will be required to pay a 100% tax on any net
income from prohibited transactions. Prohibited transactions
are, in general, sales or other taxable dispositions of
property, other than foreclosure property, held primarily for
sale to customers in the ordinary course of business. Under
existing law, whether property is held as inventory or primarily
for sale to customers in the ordinary course of a trade or
business depends on all the facts and circumstances surrounding
the particular transaction.

If we fail to satisfy the 75% gross income test
or the 95% gross income test discussed below, but nonetheless
maintain our qualification as a REIT because certain other
requirements are met, we will be subject to a tax equal to:



| |   |                                                                                                                                                                                                                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the greater of (1) the amount by which 75%
    of our gross income exceeds the amount qualifying under the 75%
    gross income test described below, and (2) the amount by
    which 90% of our gross income exceeds the amount qualifying
    under the 95% gross income test described below, multiplied by,
|
| |  | a fraction intended to reflect our profitability.                                                                                                                                                                                                                                                              

We will be required to pay a 4% excise tax on the
excess of the required distribution over the amounts actually
distributed if we fail to distribute during each calendar year
at least the sum of:



| |   |                                                                                      
| | - | -------------------------------------------------------------------------------------
| |  | 85% of our real estate investment trust ordinary
    income for the year;            
|
| |  | 95% of our real estate investment trust capital
    gain net income for the year; and
|
| |  | any undistributed taxable income from prior
    periods.                             

This distribution requirement is in addition to,
and different from the distribution requirements discussed below
in the section entitled  Distributions
Generally.

If we acquire any asset from a corporation which
is or has been taxed as a C corporation under the Internal
Revenue Code in a transaction in which the basis of the asset in
our hands is determined by reference to the basis of the asset
in the hands of the C corporation, and we subsequently
recognize gain on the disposition of the asset during the
10-year period beginning on the date on which we acquired the
asset, then we will be required to pay tax at the highest
regular corporate tax rate on this gain to the extent of the
excess of:



| |   |                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------
| |  | the fair market value of the asset, over                                                                   
|
| |  | our adjusted basis in the asset, in each case
    determined as of the date on which we acquired the asset.

A C corporation is generally defined as a
corporation required to pay full corporate-level tax. The
results described in this paragraph with respect to the
recognition of gain will apply unless we make an election under
Treasury regulation Section 1.337(d)-7(c) to cause the C
corporation to recognize all of the gain inherent in the
property at the time of acquisition of the asset.

Finally, we could be subject to an excise tax if
our dealings with any taxable REIT subsidiaries are not at
arms length.

Requirements for Qualification as a
REIT

The Internal Revenue Code defines a REIT as a
corporation, trust or association:



| |                                                              
| | -------------------------------------------------------------
| | (i) that is managed by one or more trustees
    or directors;

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| |                                                                                                                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (ii) that issues transferable shares or
    transferable certificates to evidence beneficial ownership;                                                                                                                       
|
| | (iii) that would be taxable as a domestic
    corporation but for Sections 856 through 859 of the
    Internal Revenue Code;                                                                                                  
|
| | (iv) that is not a financial institution or
    an insurance company within the meaning of the Internal Revenue
    Code;                                                                                                     
|
| | (v) that is beneficially owned by 100 or
    more persons;                                                                                                                                                                    
|
| | (vi) not more than 50% in value of the
    outstanding stock of which is owned, actually or constructively,
    by five or fewer individuals, including specified entities,
    during the last half of each taxable year; and
|
| | (vii) that meets other tests, described
    below, regarding the nature of its income and assets and the
    amount of its distributions.                                                                                     

The Internal Revenue Code provides that all of
the first four conditions stated above must be met during the
entire taxable year and that the fifth condition must be met
during at least 335 days of a taxable year of
12 months, or during a proportionate part of a taxable year
of less than 12 months. The fifth and sixth conditions do
not apply until after the first taxable year for which an
election is made to be taxed as a REIT.

Stock Ownership Tests

Our stock must be beneficially held by at least
100 persons, which we refer to as the
100 stockholder rule, and no more than 50% of
the value of our stock may be owned, directly or indirectly, by
five or fewer individuals at any time during the last half of
the taxable year, which we refer to as the
5/50 rule. In determining whether five or fewer
individuals hold our shares, certain attribution rules of the
Internal Revenue Code apply. For purposes of the 5/50 rule,
pension trusts and other specific tax-exempt entities generally
are treated as individuals, except that certain tax-qualified
pension funds are not considered individuals and beneficiaries
of such trusts are treated as holding shares of a REIT in
proportion to their actuarial interests in the trust for
purposes of the 5/50 rule. Our charter imposes repurchase
provisions and transfer restrictions to avoid having more than
50% of the value of our stock being held by five or fewer
individuals. These stock ownership requirements must be
satisfied in each taxable year other than the first taxable year
for which an election is made to be taxed as a REIT. We are
required to solicit information from certain of our record
stockholders to verify actual stock ownership levels, and our
charter provides for restrictions regarding the transfer of our
stock in order to aid in meeting the stock ownership
requirements. We will be treated as satisfying the
5/50 rule if we comply with the demand letter and record
keeping requirements discussed below, and if we do not know, and
by exercising reasonable diligence would not have known, whether
we failed to satisfy the 5/50 rule. We satisfied the stock
ownership tests immediately following our initial public
offering and we will use reasonable efforts to monitor our stock
ownership in order to ensure continued compliance with these
tests. If we were to fail either of the stock ownership tests,
we would generally be disqualified from REIT status.

To monitor our compliance with the stock
ownership tests, we are required to maintain records regarding
the actual ownership of our shares of stock. To do so, we are
required to demand written statements each year from the record
holders of certain percentages of our shares of stock in which
the record holders are to disclose the actual owners of the
shares (i.e., the persons required to include our dividends in
gross income). A REIT with 2,000 or more record stockholders
must demand statements from record holders of 5% or more of its
shares, one with fewer than 2,000, but more than 200, record
stockholders must demand statements from record holders of 1% or
more of the shares, while a REIT with 200 or fewer record
stockholders must demand statements from record holders of 0.5%
or more of the shares. A list of those persons failing or
refusing to comply with this demand must be maintained as part
of our records. A stockholder who fails or refuses to comply
with the demand must submit a statement with his tax return
disclosing the actual ownership of the shares of stock and
certain other information.

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Income Tests

We must satisfy two gross income requirements
annually to maintain our qualification as a REIT:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | under the 75% gross income test, we
    must derive at least 75% of our gross income, excluding gross
    income from prohibited transactions, from specified real estate
    sources, including rental income, interest on obligations
    secured by mortgages on real property or on interests in real
    property, gain from the disposition of qualified real
    estate assets, i.e., interests in real property, mortgages
    secured by real property or interests in real property, and some
    other assets, and income from certain types of temporary
    investments; and
|
| |  | under the 95% gross income test, we
    must derive at least 95% of our gross income, excluding gross
    income from prohibited transactions, from (1) the sources
    of income that satisfy the 75% gross income test,
    (2) dividends, interest and gain from the sale or
    disposition of stock or securities, including some interest rate
    swap and cap agreements, options, futures and forward contracts
    entered into to hedge variable rate debt incurred to acquire
    qualified real estate assets, or (3) any combination of the
    foregoing.                   

For purposes of the 75% and 95% gross income
tests, a REIT is deemed to have earned a proportionate share of
the income earned by any partnership, or any limited liability
company treated as a partnership for U.S. federal income
tax purposes, in which it owns an interest, which share is
determined by reference to its capital interest in such entity,
and is deemed to have earned the income earned by any qualified
REIT subsidiary (in general, a 100% owned corporate subsidiary
of a REIT).

Any amount includable in our gross income with
respect to a regular or residual interest in a REMIC generally
also is treated as interest on an obligation secured by a
mortgage on real property. If, however, less than 95% of the
assets of a REMIC consists of real estate assets (determined as
if we held such assets), we will be treated as receiving
directly our proportionate share of the income of the REMIC. In
addition, if we receive interest income with respect to a
mortgage loan that is secured by both real property and other
property and the highest principal amount of the loan
outstanding during a taxable year exceeds the fair market value
of the real property on the date we became committed to make or
purchase the mortgage loan, a portion of the interest income,
equal to (1) such highest principal amount minus such
value, divided by (2) such highest principal amount,
generally will not be qualifying income for purposes of the 75%
gross income test. Interest income received with respect to
non-REMIC pay-through bonds and pass-through debt instruments,
such as collateralized mortgage obligations or CMOs, however,
will not be qualifying income for this purpose.

Interest earned by a REIT ordinarily does not
qualify as income meeting the 75% or 95% gross income tests if
the determination of all or some of the amount of interest
depends in any way on the income or profits of any person.
Interest will not be disqualified from meeting such tests,
however, solely by reason of being based on a fixed percentage
or percentages of receipts or sales.

If we fail to satisfy one or both of the 75% or
95% gross income tests for any taxable year, we may nevertheless
qualify as a REIT for the year if we are entitled to relief
under the Internal Revenue Code. Generally, we may avail
ourselves of the relief provisions if:



| |   |                                                                                                 
| | - | ------------------------------------------------------------------------------------------------
| |  | our failure to meet these tests was due to
    reasonable cause and not due to willful neglect; 
|
| |  | we attach a schedule of the sources of our income
    to our U.S. federal income tax return; and
|
| |  | any incorrect information on the schedule was not
    due to fraud with intent to evade tax.    

If we are entitled to avail ourselves of the
relief provisions, we will maintain our qualification as a REIT
but will be subject to certain penalty taxes as described above.
We may not, however, be entitled to the benefit of these relief
provisions in all circumstances. If these relief provisions do
not apply to a particular set of circumstances, we will not
qualify as a REIT.

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Asset Tests

At the close of each quarter of our taxable year,
we must satisfy four tests relating to the nature and
diversification of our assets:



| |   |                                                                                                                                                                                                                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | at least 75% of the value of our total assets
    must be represented by qualified real estate assets, cash, cash
    items and government securities;                                                                                                                                                                                                      
|
| |  | not more than 25% of our total assets may be
    represented by securities, other than those securities included
    in the 75% asset test;                                                                                                                                                                                                                 
|
| |  | of the investments included in the 25% asset
    class, the value of any one issuers securities may not
    exceed 5% of the value of our total assets, and we generally may
    not own more than 10% by vote or value of any one issuers
    outstanding securities, in each case except with respect to
    stock of any taxable REIT subsidiaries; and
|
| |  | the value of the securities we own in any taxable
    REIT subsidiaries may not exceed 20% of the value of our total
    assets.                                                                                                                                                                                                                            

Qualified real estate assets include interests in
mortgages on real property to the extent the principal balance
of a mortgage does not exceed the fair market value of the
associated real property, regular or residual interests in a
REMIC (except that, if less than 95% of the assets of a REMIC
consists of real estate assets (determined as if we
held such assets), we will be treated as holding directly our
proportionate share of the assets of such REMIC), and shares of
other REITs. Non-REMIC CMOs, however, do not qualify as
qualified real estate assets for this purpose.

A taxable REIT subsidiary is any
corporation in which we own stock and as to which we and such
corporation jointly elect to treat such corporation as a taxable
REIT subsidiary. For purposes of the asset tests, we will be
deemed to own a proportionate share of the assets of any
partnership, or any limited liability company treated as a
partnership for U.S. federal income tax purposes, in which
we own an interest, which share is determined by reference to
our capital interest in the entity, and will be deemed to own
the assets owned by any qualified REIT subsidiary and any other
entity that is disregarded for U.S. federal income tax
purposes.

After initially meeting the asset tests at the
close of any quarter, we will not lose our status as a REIT for
failure to satisfy the asset tests at the end of a later quarter
solely by reason of changes in asset values. If we fail to
satisfy the asset tests because we acquire securities or other
property during a quarter, we can cure this failure by disposing
of sufficient non-qualifying assets within 30 days after
the close of that quarter. For this purpose, an increase in our
capital interest in any partnership or limited liability company
in which we own an interest will be treated as an acquisition of
a portion of the securities or other property owned by that
partnership or limited liability company.

We may at some point securitize mortgage loans
and/or mortgage-backed securities. If we were to securitize
mortgage-related assets ourselves on a regular basis (other than
through the issuance of non-REMIC CMOs), there is a substantial
risk that the securities could be dealer property
and that all of the profits from such sales would be subject to
tax at the rate of 100% as income from prohibited transactions.
Accordingly, where we intend to sell the securities created by
that process, we expect that we will engage in the
securitization through one or more taxable REIT subsidiaries,
which will not be subject to this 100% tax. We also may
securitize such mortgage-related assets through the issuance of
non-REMIC CMOs, whereby we retain an equity interest in the
mortgage-backed assets used as collateral in the securitization
transaction. The issuance of any such instruments could result
in a portion of our assets being classified as a taxable
mortgage pool, which would be treated as a separate corporation
for U.S. federal income tax purposes, which in turn could
jeopardize our status as a REIT. We intend to structure our
securitizations in a manner that would not result in the
creation of taxable mortgage pool.

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Annual Distribution Requirements

To maintain our qualification as a REIT, we are
required to distribute dividends, other than capital gain
dividends, to our stockholders in an amount at least equal to:



| |   |                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------
| |  | 90% of our REIT taxable net income, plus                                                                                             
|
| |  | 90% of our after tax net income, if any, from
    foreclosure property, minus                                                        
|
| |  | the excess of the sum of specified items of our
    non-cash income items over 5% of REIT taxable net income, as
    described below.

For purposes of these distribution requirements,
our REIT taxable net income is computed without
regard to the dividends paid deduction and net capital gain. In
addition, for purposes of this test, the specified items of
non-cash income include income attributable to leveled stepped
rents, certain original issue discount, certain like-kind
exchanges that are later determined to be taxable and income
from cancellation of indebtedness. In addition, if we disposed
of any asset we acquired from a corporation which is or has been
a C corporation in a transaction in which our basis in the asset
is determined by reference to the basis of the asset in the
hands of that C corporation and we did not elect to
recognize gain currently in connection with the acquisition of
such asset, we would be required to distribute at least 90% of
the after-tax gain, if any, we recognize on a disposition of the
asset within the 10 year period following our acquisition
of such asset, to the extent that such gain does not exceed the
excess of:



| |   |                                                                               
| | - | ------------------------------------------------------------------------------
| |  | the fair market value of the asset on the date we
    acquired the asset, over
|
| |  | our adjusted basis in the asset on the date we
    acquired the asset.        

Only distributions that qualify for the
dividends paid deduction available to REITs under
the Internal Revenue Code are counted in determining whether the
distribution requirements are satisfied. We must make these
distributions in the taxable year to which they relate, or in
the following taxable year if they are declared before we timely
file our tax return for that year, paid on or before the first
regular dividend payment following the declaration and we elect
on our tax return to have a specified dollar amount of such
distributions treated as if paid in the prior year. For these
and other purposes, dividends declared by us in October,
November or December of one taxable year and payable to a
stockholder of record on a specific date in any such month shall
be treated as both paid by us and received by the stockholder
during such taxable year, provided that the dividend is actually
paid by us by January 31 of the following taxable year.

In addition, dividends distributed by us must not
be preferential. If a dividend is preferential, it will not
qualify for the dividends paid deduction. To avoid being
preferential, every stockholder of the class of stock to which a
distribution is made must be treated the same as every other
stockholder of that class, and no class of stock may be treated
other than according to its dividend rights as a class.

To the extent that we do not distribute all of
our net capital gain, or we distribute at least 90%, but less
than 100%, of our REIT taxable net income, as adjusted, we will
be required to pay tax on this undistributed income at regular
ordinary and capital gain corporate tax rates. Furthermore, if
we fail to distribute during each calendar year (or, in the case
of distributions with declaration and record dates falling in
the last three months of the calendar year, by the end of the
January immediately following such year) at least the sum of
(1) 85% of our REIT ordinary income for such year,
(2) 95% of our REIT capital gain income for such year, and
(3) any undistributed taxable income from prior periods, we
will be subject to a 4% nondeductible excise tax on the excess
of such required distribution over the amounts actually
distributed. We intend to make timely distributions sufficient
to satisfy the annual distribution requirements.

Under certain circumstances, we may be able to
rectify a failure to meet the distribution requirements for a
year by paying deficiency dividends to its
stockholders in a later year, which may be included in our
deduction for dividends paid for the earlier year. Although we
may be able to avoid being taxed on

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amounts distributed as deficiency dividends, we
will be required to pay to the IRS interest based upon the
amount of any deduction taken for deficiency dividends.


Failure to Qualify as a REIT

If we fail to qualify for taxation as a REIT in
any taxable year, and the relief provisions of the Internal
Revenue Code do not apply, we will be required to pay taxes,
including any applicable alternative minimum tax, on our taxable
income in that taxable year and all subsequent taxable years at
regular corporate rates. Distributions to our stockholders in
any year in which we fail to qualify as a REIT will not be
deductible by us and we will not be required to distribute any
amounts to our stockholders. As a result, we anticipate that our
failure to qualify as a REIT would reduce the cash available for
distribution to our stockholders. In addition, if we fail to
qualify as a REIT, all distributions to our stockholders will be
taxable at ordinary income rates to the extent of our current
and accumulated earnings and profits. In this event, corporate
distributees may be eligible for the dividends-received
deduction. Unless entitled to relief under specific statutory
provisions, we will also be disqualified from taxation as a REIT
for the four taxable years following the year in which we lose
our qualification.

Taxation of Taxable United States
Stockholders

For purposes of the discussion in this
Form 10-K, the term United States stockholder
means a beneficial holder of our stock that is, for
U.S. federal income tax purposes:



| |   |                                                                                                                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a citizen or resident of the United States (as
    determined for U.S. federal income tax purposes);                                                                                                                         
|
| |  | a corporation, partnership, or other entity
    created or organized in or under the laws of the United States
    or of any state thereof or in the District of Columbia, unless
    Treasury regulations provide otherwise;
|
| |  | an estate the income of which is subject to
    U.S. federal income taxation regardless of its
    source; or                                                                                                                
|
| |  | a trust whose administration is subject to the
    primary supervision of a U.S. court and which has one or
    more U.S. persons who have the authority to control all
    substantial decisions of the trust.              



| |                        
| | -----------------------
| | Distributions Generally

Distributions out of our current or accumulated
earnings and profits, other than capital gain dividends, will be
taxable to United States stockholders as ordinary dividends.
Such REIT dividends generally are ineligible for the new reduced
15% tax rate for dividends received by individuals, trusts and
estates. However, such rate will apply to the extent that we
make distributions attributable to amounts, if any, we receive
as dividends from non-REIT corporations or to the extent that we
make distributions attributable to income that was subject to
tax at the REIT level. Provided that we qualify as a REIT,
dividends paid by us will not be eligible for the dividends
received deduction generally available to United States
stockholders that are corporations. To the extent that we make
distributions in excess of current and accumulated earnings and
profits, the distributions will be treated as a tax-free return
of capital to each United States stockholder, and will reduce
the adjusted tax basis that each United States stockholder has
in our stock by the amount of the distribution, but not below
zero. Distributions in excess of a United States
stockholders adjusted tax basis in its stock will be
taxable as capital gain, and will be taxable as long-term
capital gain if the stock has been held for more than one year.
The calculation of the amount of distributions that are applied
against or exceed adjusted tax basis are made on a
share-by-share basis. To the extent that we make distributions,
if any, that are attributable to excess inclusion income, such
amounts may not be offset by net operating losses of a United
States stockholder. If we declare a dividend in October,
November, or December of any calendar year which is payable to
stockholders of record on a specified date in such a month and
actually pay the dividend during January of the following
calendar year, the dividend is deemed to be paid by us and
received by the stockholder on December 31st of the
year preceding the year of payment. Stockholders may not include
in their own income tax returns any of our net operating losses
or capital losses.

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| |                           
| | --------------------------
| | Capital Gain Distributions

Distributions designated by us as capital gain
dividends will be taxable to United States stockholders as
capital gain income. We can designate distributions as capital
gain dividends to the extent of our net capital gain for the
taxable year of the distribution. For tax years prior to 2009,
this capital gain income will generally be taxable to
non-corporate United States stockholders at a 15% or 25% rate
based on the characteristics of the asset we sold that produced
the gain. United States stockholders that are corporations may
be required to treat up to 20% of certain capital gain dividends
as ordinary income.



| |                                   
| | ----------------------------------
| | Retention of Net Capital
    Gains

We may elect to retain, rather than distribute as
a capital gain dividend, our net capital gains. If we were to
make this election, we would pay tax on such retained capital
gains. In such a case, our stockholders would generally:



| |   |                                                                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | include their proportionate share of our
    undistributed net capital gains in their taxable income;                                                                                  
|
| |  | receive a credit for their proportionate share of
    the tax paid by us in respect of such net capital gain; and                                                                      
|
| |  | increase the adjusted basis of their stock by the
    difference between the amount of their share of our
    undistributed net capital gain and their share of the tax paid
    by us.



| |                                                                                                               
| | --------------------------------------------------------------------------------------------------------------
| | Passive Activity Losses, Investment
    Interest Limitations and Other Considerations of Holding Our
    Stock

Distributions we make, undistributed net capital
gain includible in income and gains arising from the sale or
exchange of our stock by a United States stockholder will not be
treated as passive activity income. As a result, United States
stockholders will not be able to apply any passive
losses against income or gains relating to our stock.
Distributions by us, to the extent they do not constitute a
return of capital, and undistributed net capital gain includible
in our stockholders income, generally will be treated as
investment income for purposes of computing the investment
interest limitation under the Internal Revenue Code, provided
the proper election is made. If we, or a portion of our assets,
were to be treated as a taxable mortgage pool, or if we were to
acquire REMIC residual interests, our stockholders (other than
certain thrift institutions) may not be permitted to offset
certain portions of the dividend income they derive from our
shares with their current deductions or net operating loss
carryovers or carrybacks. The portion of a stockholders
dividends that will be subject to this limitation will equal the
allocable share of our excess inclusion income.



| |                      
| | ---------------------
| | Dispositions of Stock

A United States stockholder that sells or
disposes of our stock will recognize gain or loss for federal
income tax purposes in an amount equal to the difference between
the amount of cash or the fair market value of any property the
stockholder receives on the sale or other disposition and the
stockholders adjusted tax basis in the stock. This gain or
loss generally will be capital gain or loss and will be
long-term capital gain or loss if the stockholder has held the
stock for more than one year. However, any loss recognized by a
United States stockholder upon the sale or other disposition of
our stock that the stockholder has held for six months or less
will be treated as long-term capital loss to the extent the
stockholder received distributions from us which were required
to be treated as long-term capital gains. For tax years prior to
2009, capital gain of an individual United States stockholder is
generally taxed at a maximum rate of 15% where the property is
held for more than one year. The deductibility of capital loss
is limited.



| |                                                 
| | ------------------------------------------------
| | Information Reporting and Backup
    Withholding

We report to our United States stockholders and
the IRS the amount of dividends paid during each calendar year,
along with the amount of any tax withheld. Under the backup
withholding rules, a stockholder may be subject to backup
withholding with respect to dividends paid and redemption
proceeds

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unless the holder is a corporation or comes
within other exempt categories and, when required, demonstrates
this fact, or provides a taxpayer identification number or
social security number, certifying as to no loss of exemption
from backup withholding, and otherwise complies with applicable
requirements of the backup withholding rules. A United States
stockholder that does not provide. us with its correct taxpayer
identification number or social security number may also be
subject to penalties imposed by the IRS. A United States
stockholder can meet this requirement by providing us with a
correct, properly completed and executed copy of IRS
Form W-9 or a substantially similar form. Backup
withholding is not an additional tax. Any amount paid as backup
withholding will be creditable against the stockholders
income tax liability, if any, and otherwise be refundable,
provided the proper forms are filed on a timely basis. In
addition, we may be required to withhold a portion of capital
gain distributions made to any stockholders who fail to certify
their non-foreign status. The backup withholding tax rate
currently is 28%.


Taxation of Tax-Exempt Stockholders

The IRS has ruled that amounts distributed as a
dividend by a REIT will be treated as a dividend by the
recipient and excluded from the calculation of unrelated
business taxable income when received by a tax-exempt entity.
Based on that ruling, provided that a tax-exempt stockholder has
not held our stock as debt financed property within
the meaning of the Internal Revenue Code, i.e., property the
acquisition or holding of which is or is treated as financed
through a borrowing by the tax-exempt United States stockholder,
the stock is not otherwise used in an unrelated trade or
business, and we do not hold an asset that gives rise to
excess inclusion income, as defined in
Section 860E of the Internal Revenue Code, dividend income
on our stock and income from the sale of our stock should not be
unrelated business taxable income to a tax-exempt stockholder.
However, if we were to hold residual interests in a REMIC, or if
we or a pool of our assets were to be treated as a taxable
mortgage pool, a portion of the dividends paid to a tax-exempt
stockholder may be subject to tax as unrelated business taxable
income. Although we do not believe that we, or any portion of
our assets, will be treated as a taxable mortgage pool, we
cannot assure you that that the IRS might not successfully
maintain that such a taxable mortgage pool exists.

For tax-exempt stockholders that are social
clubs, voluntary employees beneficiary associations,
supplemental unemployment benefit trusts, and qualified group
legal services plans exempt from U.S. federal income
taxation under Sections 501(c)(7), (c)(9), (c)(17) and
(c)(20) of the Internal Revenue Code, respectively, income from
an investment in our stock will constitute unrelated business
taxable income unless the organization is able to properly claim
a deduction for amounts set aside or placed in reserve for
certain purposes so as to offset the income generated by its
investment in our stock. Any prospective investors should
consult their tax advisors concerning these set
aside and reserve requirements.

Notwithstanding the above, however, a substantial
portion of the dividends received with respect to our stock may
constitute unrelated business taxable income, or UBTI, if we are
treated as a pension-held REIT and you are a pension
trust which:



| |   |                                                                     
| | - | --------------------------------------------------------------------
| |  | is described in Section 401(a) of the
    Internal Revenue Code; and
|
| |  | holds more than 10%, by value, of our equity
    interests.         

Tax-exempt pension funds that are described in
Section 401 (a) of the Internal Revenue Code and
exempt from tax under Section 501(a) of the Internal
Revenue Code are referred to below as qualified
trusts. A REIT is a pension-held REIT if:



| |   |                                                                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | it would not have qualified as a REIT but for the
    fact that Section 856(h)(3) of the Internal Revenue Code
    provides that stock owned by a qualified trust shall be treated,
    for purposes of the 5/50 rule, described above, as owned by the
    beneficiaries of the trust, rather than by the trust
    itself; and
|
| |  | either at least one qualified trust holds more
    than 25%, by value, of the interests in the REIT, or one or more
    qualified trusts, each of which owns more than 10%, by value, of
    the interests in the REIT, holds in the aggregate more than 50%,
    by value, of the interests in the REIT.                       

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The percentage of any REIT dividends treated as
unrelated business taxable income under these rules is equal to
the ratio of:



| |   |                                                                                                                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the unrelated business taxable income earned by
    the REIT, less directly related expenses, treating the REIT as
    if it were a qualified trust and therefore subject to tax on
    unrelated business taxable income, to
|
| |  | the total gross income, less directly related
    expenses, of the REIT.                                                                                                                                                     

A de minimis exception applies where this
percentage is less than 5% for any year. As a result of the
limitations on the transfer and ownership of stock contained in
our charter, we do not expect to be classified as a pension-held
REIT.

Taxation of Non-United States
Stockholders

The rules governing U.S. federal income
taxation of non-United States stockholders are complex and no
attempt will be made herein to provide more than a summary of
these rules. Non-United States stockholders mean
beneficial owners of shares of our stock that are not United
States stockholders (as such term is defined in the discussion
above under the heading entitled Taxation of Taxable
United States Stockholders).

PROSPECTIVE NON-U.S. STOCKHOLDERS SHOULD
CONSULT THEIR TAX ADVISORS TO DETERMINE THE IMPACT OF FOREIGN,
FEDERAL, STATE, AND LOCAL INCOME TAX LAWS WITH REGARD TO AN
INVESTMENT IN OUR STOCK AND OF OUR ELECTION TO BE TAXED AS A
REAL ESTATE INVESTMENT TRUST, INCLUDING ANY REPORTING
REQUIREMENTS.

Distributions to non-United States stockholders
that are not attributable to gain from our sale or exchange of
U.S. real property interests and that are not designated by
us as capital gain dividends or retained capital gains will be
treated as dividends of ordinary income to the extent that they
are made out of our current or accumulated earnings and profits.
These distributions will generally be subject to a withholding
tax equal to 30% of the distribution unless an applicable tax
treaty reduces or eliminates that tax. However, if income from
an investment in our stock is treated as effectively connected
with the non-United States stockholders conduct of a
U.S. trade or business (or, if an income tax treaty
applies, is attributable to a U.S. permanent establishment
of the non-United States stockholder), the non-United States
stockholder generally will be subject to federal income tax at
graduated rates in the same manner as United States stockholders
are taxed with respect to those distributions, and also may be
subject to the 30% branch profits tax in the case of a
non-United States stockholder that is a corporation, unless a
treaty reduces or eliminates these taxes. We expect to
withhold-tax at the rate of 30% on the gross amount of any
distributions made to a non-United States stockholder unless:



| |   |                                                                                                                                                                                                   
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a lower treaty rate applies and any required
    form, for example IRS Form W-8BEN, evidencing eligibility
    for that reduced rate is filed by the non-United States
    stockholder with us; or
|
| |  | the non-United States stockholder files an IRS
    Form W-8ECI with us claiming that the distribution is
    effectively connected income.                                                        

Any portion of the dividends paid to non-United
States stockholders that is treated as excess inclusion income
will not be eligible for exemption from the 30% withholding tax
or a reduced treaty rate.

Distributions in excess of our current and
accumulated earnings and profits that are not treated as
attributable to the gain from our disposition of a
U.S. real property interest will not be taxable to
non-United States stockholders to the extent that these
distributions do not exceed the adjusted basis of the
stockholders stock, but rather will reduce the adjusted
basis of that stock. To the extent that distributions in excess
of current and accumulated earnings and profits exceed the
adjusted basis of a non-United States stockholders stock,
these distributions will give rise to tax liability if the
non-United States stockholder would otherwise be subject to tax
on any gain from the sale or disposition of its stock, as
described below. Because it generally cannot be determined at
the time a distribution is made whether or not such

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distribution may be in excess of current and
accumulated earnings and profits, the entire amount of any
distribution normally will be subject to withholding at the same
rate as a dividend. However, amounts so withheld are creditable
against U.S. tax liability, if any, or refundable by the
IRS to the extent the distribution is subsequently determined to
be in excess of our current and accumulated earnings and profits
and the proper forms are filed with the IRS by the stockholder
on a timely basis. We are also required to withhold 10% of any
distribution in excess of our current and accumulated earnings
and profits if our stock is a U.S. real property interest
because we are not a domestically controlled REIT, as discussed
below. Consequently, although we intend to withhold at a rate of
30% on the entire amount of any distribution, to the extent that
we do not do so, any portion of a distribution not subject to
withholding at a rate of 30% may be subject to withholding at a
rate of 10%.


Distributions attributable to our capital gains
which are not attributable to gain from the sale or exchange of
a U.S. real property interest generally will not be subject
to income taxation, unless (1) investment in our stock is
effectively connected with the non-United States
stockholders U.S. trade or business (or, if an income
tax treaty applies, is attributable to a U.S. permanent
establishment of the non-United States stockholder), in which
case the non-United States stockholder will be subject to the
same treatment as United States stockholders with respect to
such gain (and a corporate non-United States stockholder may
also be subject to the 30% branch profits tax), or (2) the
non-United States stockholder is a non-resident alien individual
who is present in the U.S. for 183 days or more during
the taxable year and certain other conditions are satisfied, in
which case the non-resident alien individual will be subject to
a 30% tax on the individuals capital gains.

For any year in which we qualify as a REIT,
distributions that are attributable to gain from the sale or
exchange of a U.S. real property interest, which includes
some interests in real property, but generally does not include
an interest solely as a creditor in mortgage loans or
mortgage-backed securities, will be taxed to a non- United
States stockholder under the provisions of the Foreign
Investment in Real Property Tax Act, or FIRPTA. Under FIRPTA,
distributions attributable to gain from sales of U.S. real
property interests are taxed to a non-United States stockholder
as if that gain were effectively connected with the
stockholders conduct of a U.S. trade or business.
Non-United States stockholders thus would be taxed at the normal
capital gain rates applicable to United States stockholders,
subject to applicable alternative minimum tax and a special
alternative minimum tax in the case of nonresident alien
individuals. Distributions subject to FIRPTA also may be subject
to the 30% branch profits tax in the hands of a
non-U.S. corporate stockholder. We are required to withhold
35% of any distribution paid to a non-United States stockholder
that we designate (or, if greater, the amount that we could
designate) as a capital gains dividend. The amount withheld is
creditable against the non-United States stockholders
FIRPTA tax liability, provided the proper forms are filed on a
timely basis.

Gains recognized by a non-United States
stockholder upon a sale of our stock generally will not be taxed
under FIRPTA if we are a domestically controlled REIT, which is
a REIT in which at all times during a specified testing period
less than 50% in value of the stock was held directly or
indirectly by non-United States stockholders. Because our stock
is publicly traded/widely held, we cannot assure our investors
that we are or will remain a domestically controlled REIT. Even
if we are not a domestically controlled REIT, however, a
non-United States stockholder that owns, actually or
constructively, 5% or less of our stock throughout a specified
testing period will not recognize taxable gain on the sale of
our stock under FIRPTA if our shares are traded on an
established securities market.

If gain from the sale of the stock were subject
to taxation under FIRPTA, the non-United States stockholder
would be subject to the same treatment as United States
stockholders with respect to that gain, subject to applicable
alternative minimum tax, a special alternative minimum tax in
the case of nonresident alien individuals, and the possible
application of the 30% branch profits tax in the case of
non-U.S. corporations. In addition, the purchaser of the
stock could be required to withhold 10% of the purchase price
and remit such amount to the IRS.

Gains not subject to FIRPTA will be taxable to a
non-United States stockholder if the non-United States
stockholders investment in the stock is effectively
connected with a trade or business in the

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U.S. (or, if an income tax treaty applies,
is attributable to a U.S. permanent establishment of the
non-United States stockholder), in which case the non-United
States stockholder will be subject to the same treatment as
United States stockholders with respect to that gain; or the
non-United States stockholder is a nonresident alien individual
who was present in the U.S. for 183 days or more
during the taxable year and other conditions are met, in which
case the nonresident alien individual will be subject to a 30%
tax on the individuals capital gains.


Information Reporting and Backup Withholding
for Non-United States Stockholders

If the proceeds of a disposition of our stock are
paid by or through a U.S. office of a broker-dealer, the
payment is generally subject to information reporting and to
backup withholding (currently at a rate of 28%) unless the
disposing non-United States stockholder certifies as to his
name, address and non-U.S. status or otherwise establishes
an exemption. Generally, U.S. information reporting and
backup withholding will not apply to a payment of disposition
proceeds if the payment is made outside the U.S. through a
foreign office of a foreign broker-dealer. If the proceeds from
a disposition of our stock are paid to or through a foreign
office of a U.S. broker-dealer or a non-U.S. office of
a foreign broker-dealer that is (1) a controlled
foreign corporation for U.S. federal income tax
purposes, (2) a foreign person 50% or more of whose gross
income from all sources for a three-year period was effectively
connected with a U.S. trade or business, (3) a foreign
partnership with one or more partners who are U.S. persons
and who in the aggregate hold more than 50% of the income or
capital interest in the partnership, or (4) a foreign
partnership engaged in the conduct of a trade or business in the
U.S., then (a) backup withholding will not apply unless the
broker-dealer has actual knowledge that the owner is not a
foreign stockholder, and (b) information reporting will not
apply if the non-United States stockholder satisfies
certification requirements regarding its status as a foreign
stockholder. Other information reporting rules apply to
non-United States stockholders, and prospective non-United
States stockholders should consult their own tax advisors
regarding these requirements.

New Legislation and Possible Legislative or
Other Action Affecting Tax Consequences

Recently enacted legislation reduced the maximum
tax rate of non-corporate taxpayers for capital gains generally
from 20% to 15% (for taxable years ending on or after
May 6, 2003 and before January 1, 2009) and for
dividends payable to non-corporate taxpayers generally from
38.6% to 15% (for taxable years beginning after
December 31, 2002 and before January 1, 2009). As
discussed above at Taxation of Taxable United States
Stockholders  Distributions Generally,
dividends paid by REITs are generally not eligible for the new
15% federal income tax rate, with certain exceptions. Although
this legislation does not adversely affect the taxation of REITs
or dividends paid by REITs, the more favorable treatment of
regular corporate dividends could cause investors who are
individuals to consider stocks of other corporations that pay
dividends as more attractive relative to stocks of REITs. It is
not possible to predict whether this change in perceived
relative value will occur, or what the effect will be on the
market price of our stock.

You should recognize that the present
U.S. federal income tax treatment of an investment in us
may be modified by legislative, judicial or administrative
action at any time and that any such action may affect
investments and commitments previously made. The rules dealing
with U.S. federal income taxation are constantly under
review by persons involved in the legislative process and by the
Internal Revenue Service and the Treasury Department, resulting
in revisions of regulations and revised interpretations of
established concepts as well as statutory changes. Revisions in
federal tax laws and interpretations thereof could affect the
tax consequences of an investment in us.

In particular, legislation was recently
introduced in both the United States House of Representatives
and the United States Senate that would amend certain rules
relating to REITs. Among other changes, the proposed legislation
would provide the Internal Revenue Service with the ability to
impose monetary penalties, rather than a loss of REIT status,
for reasonable cause violations of certain tests relating to
REIT qualification. The proposed legislation would also change
the formula for calculating the tax imposed for certain
violations of the 75% and 95% gross income tests discussed above
at  Requirements

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for Qualification as a REIT  Income
Tests. In general, the changes would apply to taxable
years beginning after the date the legislation is enacted. As of
the date hereof, this legislation has not been enacted into law,
and it is not possible to predict with any certainty whether the
proposed legislation will be enacted in its current form.


State, Local and Foreign Taxation

We may be required to pay state, local and
foreign taxes in various state, local and foreign jurisdictions,
including those in which we transact business or make
investments, and our stockholders may be required to pay state,
local and foreign taxes in various state, local and foreign
jurisdictions, including those in which they reside. Our state,
local and foreign tax treatment may not conform to the federal
income tax consequences summarized above. In addition, a
stockholders state, local and foreign tax treatment may
not conform to the federal income tax consequences summarized
above. Consequently, prospective investors should consult their
tax advisors regarding the effect of state, local and foreign
tax laws on an investment in our stock.

Employees

Our day-to-day operations are externally managed
and advised by our manager, Seneca Capital Management LLC. At
December 31, 2003 we had two full-time employees. We employ
a full-time chief financial officer, Christopher J. Zyda, whose
primary responsibilities include monitoring the Managers
performance under our Management Agreement, as well as a
full-time controller.

We do not employ any of our officers other than
Mr. Zyda. Our other executive officers are employees and/or
officers of Seneca Capital Management LLC and are compensated by
Seneca Capital Management LLC.

Website Access to our Periodic SEC
Reports

The Internet address of our corporate website is
www.luminentcapital.com. We make our periodic SEC reports
(on Forms 10-K and 10-Q) and current reports (on Form 8-K),
as well as the beneficial ownership reports filed by our
directors, officers and 10% stockholders (on Forms 3, 4 and
5) available free of charge through our website as soon as
reasonably practicable after they are filed electronically with
the SEC. We may from time to time provide important disclosures
to investors by posting them in the investor relations section
of our website, as allowed by SEC rules. The information on our
website is not a part of this Form 10-K.

Materials we file with the SEC may be read and
copied at the SECs Public Reference Room at 450 Fifth
Street, N.W., Washington, D.C. 20549. Information on the
operation of the Public Reference Room may be obtained by
calling the SEC at 1-800-SEC-0330. The SEC also maintains an
Internet website at www.sec.gov that will contain our
reports, proxy and information statements, and other information
regarding our company that we will file electronically with the
SEC.






|        |           
|------- | ----------
|Item 2. | Properties

Our principal offices are located at 909
Montgomery Street, Suite 500, San Francisco,
California 94133. We utilize approximately 1,500 square
feet of space provided by our manager.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

At December 31, 2003, there were no pending
legal proceedings to which we were party or of which any of our
properties were subject.






|        |                                                        
|------- | -------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security
    Holders

None.

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PART II






|        |                                                                                                                     
|------- | --------------------------------------------------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity,
    Related Stockholder Matters and Issuer Purchases of Equity
    Securities

Market Information

Prior to our initial public offering, our common
stock was not listed or quoted on any national exchange or
market system. However, certain of our stockholders privately
sold shares of our common stock using the PORTAL system.
Commencing December 19, 2003, our common stock has been
listed on the NYSE under the symbol LUM. The
following table sets forth the intra-day high and low sale
prices for our common stock as reported on the PORTAL Market of
which we are aware (for dates prior to December 19, 2003)
and as reported on the NYSE (for dates on or after
December 19, 2003) for each quarterly period since
June 11, 2003, the date of our private placement:

|                                    |  |              |       |     |  |   |       | 
|----------------------------------- |  | ------------ | ----- | --- |  | - | ----- | 
|                                    |  |             
|                                    |  | Common Stock
|                                    |  |             
|2003                                |  | High         |       | Low
|                                    |  |              |       |    
|Second Quarter (from June 11, 2003) |  | $            | 15.35 |     |  | $ | 15.00 | 
|Third Quarter                       |  | $            | 15.60 |     |  | $ | 15.00 | 
|Fourth Quarter                      |  | $            | 15.00 |     |  | $ | 13.00 | 

Holders

As of February 23, 2004, we had
24,841,146 shares of common stock issued and outstanding
which were held by 17 holders of record. The
17 holders of record include Cede & Co., which
holds shares as nominee for The Depository Trust Company, which
itself holds shares on behalf of hundreds of beneficial owners
of our common stock.

Distribution Policy

The following table sets forth, for the periods
indicated, the cash distributions declared per share of our
common stock since June 11, 2003, the date of our private
placement:

|                                    |  |                    |      | 
|----------------------------------- |  | ------------------ | ---- | 
|                                    |  | Cash Distributions
|2003                                |  | Declared Per Share
|                                    |  |                   
|Second Quarter (from June 11, 2003) |  | $                  |     | 
|Third Quarter                       |  | $                  | 0.50 | 
|Fourth Quarter                      |  | $                  | 0.45 | 

Our distributions declared to date are not
necessarily indicative of distributions that we will declare in
the future. We expect that future distributions will be based on
our REIT taxable net income in future periods, which we cannot
predict with any certainty. All distribution declarations are
made at the discretion of our board of directors.

On November 17, 2003, we paid a cash
distribution of $0.50 per share to our stockholders of
record on October 21, 2003. On January 28, 2004, we
paid a cash distribution of $0.45 per share to our
stockholders of record on December 11, 2003. All of the
distributions are a taxable dividend, and none of the
distribution is a return of capital. Both distributions were
payable to stockholders of the 11,704,000 shares
outstanding on each of the record dates prior to the completion
of our initial public offering. We did not distribute $282
thousand of our REIT taxable net income for the period from
April 26, 2003 through December 31, 2003. We intend to
declare a spillback distribution in this amount during 2004.

We intend to distribute all or substantially all
of our REIT taxable net income (which does not ordinarily equate
to net income as calculated in accordance with accounting
principles generally accepted in the United States, which are
known as GAAP) to our stockholders in each year. We intend to
make regular quarterly distributions to our stockholders to be
paid out of funds readily available for such

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distributions. Our distribution policy is subject
to revision at the discretion of our board of directors without
notice to you or stockholder approval. We have not established a
minimum distribution level and our ability to make distributions
may be harmed for the reasons described under the caption
Risk Factors. All distributions will be made by us
at the discretion of our board of directors and will depend on
our earnings and financial condition, maintenance of REIT
status, applicable provisions of the Maryland general
corporation law, or MGCL, and such other factors as our board of
directors deems relevant.


In order to avoid corporate income and excise tax
and to maintain our qualification as a REIT under the Internal
Revenue Code, we must make distributions to our stockholders
each year in an amount at least equal to:



| |   |                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------
| |  | 90% of our REIT taxable net income;                                                                                                    
|
| |  | plus90% of the
    excess of net income from foreclosure property over the tax
    imposed on such income by the Internal Revenue Code;
|
| |  | minusany excess
    non-cash income.                                                                                                   

In general, our distributions will be applied
toward these requirements only if paid in the taxable year to
which they relate, or in the following taxable year if the
distributions are declared before we timely file our tax return
for that year, the distributions are paid on or before the first
regular distribution payment following the declaration and we
elect on our tax return to have a specified dollar amount of
such distributions treated as if paid in the prior year.
Distributions declared by us in October, November or December of
one taxable year and payable to a stockholder of record on a
specific date in such a month are treated as both paid by us and
received by the stockholder during such taxable year, provided
that the distribution is actually paid by us by January 31 of
the following taxable year.

We anticipate that distributions generally will
be taxable as ordinary income to our stockholders, although a
portion of such distributions may be designated by us as capital
gain or may constitute a return of capital. We will furnish
annually to each of our stockholders a statement setting forth
distributions paid during the preceding year and their
characterization as ordinary income, return of capital or
capital gains.

We will seek to borrow between eight and
12 times the amount of our equity, and as of
December 31, 2003 we had established 17 borrowing
arrangements with various investment banking firms and other
lenders, 12 of which were in use on December 31, 2003.

In the future, our board of directors may elect
to adopt a dividend reinvestment plan.

Equity Compensation Plan

Effective June 4, 2003, we adopted a 2003
Stock Incentive Plan and a 2003 Outside Advisors Stock Incentive
Plan pursuant to which up to 1,000,000 shares of our common
stock is authorized to be awarded at the discretion of the
Compensation Committee of the Board of Directors. The plans
provide for the grant of a variety of long-term incentive awards
to employees and officers, individual consultants or advisors
who render or have rendered bona fide services, and officers,
employees or directors of the Manager as an additional means to
attract, motivate, retain and reward eligible persons. These
plans provide for the grant of awards that meet the requirements
of Section 422 of the Code, non-qualified stock options,
stock appreciation rights, restricted stock, stock units and
other stock-based awards, and dividend equivalent rights.

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The following table illustrates common stock
authorized for issuance under the 2003 Stock Incentive Plan and
2003 Outside Advisors Stock Incentive Plan as of
December 31, 2003:

|                                             |  |                         |        |                      |  |                          |       |  |  |  |         |    
|-------------------------------------------- |  | ----------------------- | ------ | -------------------- |  | ------------------------ | ----- |  |  |  | ------- | ---
|                                             |  |                         |        |                      |  | (c) Number of           
|                                             |  |                         |        |                      |  | Securities Remaining    
|                                             |  | (a) Number of           |        |                      |  | Available for Future    
|                                             |  | Securities to Be Issued |        | (b) Weighted-Average |  | Issuance Under Equity   
|                                             |  | Upon Exercise of        |        | Exercise Price of    |  | Compensation Plans      
|                                             |  | Outstanding Options,    |        | Outstanding Options, |  | (Excluding Securities   
|Plan Category                                |  | Warrants and Rights     |        | Warrants and Rights  |  | Reflected in Column (a))
|                                             |  |                         |        |                      |  |                         
|Incentive plans approved by stockholders     |  |                         | 55,000 |                      |  | $                        | 14.82 |  |  |  | 945,000 |    
|Incentive plans not approved by stockholders |  |                         |       |                      |  |                          |      |  |  |  |        |    
|                                             |  |                         |        |                      |  |                          |       |  |  |  |         |    
|Total                                        |  |                         | 55,000 |                      |  | $                        | 14.82 |  |  |  | 945,000 | (1)
|                                             |  |                         |        |                      |  |                          |       |  |  |  |         |    



---



|    |                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | At December 31, 2003, the maximum number of
    shares of common stock that may be delivered pursuant to awards
    granted under both plans is 945,000 shares of our common
    stock.

See Note 6 to our financial statements in
Item 8 of this annual report on Form 10-K for further
information regarding the 2003 Stock Incentive Plan and 2003
Outside Advisors Stock Incentive Plan.

Recent Sales of Unregistered
Securities

On April 25, 2003, we issued
204,000 shares of common stock to three of our officers and
seven associates of the Manager at a price of $0.001 per
share.

In two closings on June 11 and June 19,
2003, we completed a private offering of 11,092,473 shares
of our common stock, $0.001 par value at an offering price
of $15.00 per share, including the exercise by the initial
purchaser/placement agent of its over-allotment option to
purchase 1,500,000 shares of common stock. The securities
were sold to Friedman, Billings, Ramsey Group Inc., or Friedman
Billings Ramsey, the principal underwriter, and to a group of
private accredited investors. In addition, on June 11, 2003
we issued 407,527 shares of our common stock, par value
$0.001, at an offering price net of the initial purchasers
discount of $13.95 per share, to employees and affiliates
of the Manager, and other persons selected by the Manager. We
received aggregate gross offering proceeds of
$172.1 million from these transactions and paid aggregate
underwriting commissions of $11.7 million. Aggregate other
offering costs paid totaled $0.7 million. Net offering
proceeds after deducting underwriting commissions and other
offering costs was $159.7 million. On February 13,
2004, we registered the resale of these 11,500,000 shares
of our common stock with the SEC.

On August 4, 2003, we issued an employee
stock option to purchase 50,000 shares of our common stock
at an exercise price of $15.00 per share to Christopher
Zyda.

On November 3, 2003, we issued an employee
stock option to purchase 5,000 shares of our common stock
at an exercise price of $13.00 per share to our controller.

On February 4, 2004, we issued an aggregate
of 1,495 shares of our restricted common stock to employees
under our 2003 Stock Incentive Plan. In addition, on
February 4, 2004, we issued 25,651 shares of
restricted common stock to our Manager pursuant to the
provisions of our management agreement. The Manager subsequently
assigned the restricted stock to employees of the Manager, some
of whom are also officers of our company.

Use of Proceeds from Registered
Securities

In December 2003, we completed an initial public
offering of 13,110,000 shares common stock, $0.001 par
value at an offering price of $13.00 per share, including
the exercise by the underwriter of its over-allotment option to
purchase 1,710,000 shares of common stock. Our registration
statement was declared effective by the SEC on December 18,
2003 (Registration No. 333-107984). Friedman Billings

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Ramsey & Co., Inc., Credit Suisse First
Boston LLC, JMP Securities, LLC and Flagstone Securities, LLC
were the managing underwriters of the initial public offering.
We received aggregate gross offering proceeds of
$170.4 million from these transactions and paid aggregate
underwriting commissions of $11.9 million. Aggregate other
offering costs paid totaled $1.5 million. Net offering
proceeds after deducting underwriting commissions and other
offering costs was $157.0 million. At December 31,
2003 substantially all of the net offering proceeds had been
used to purchase mortgage-backed securities. However, at
December 31, 2003, we had not fully levered our portfolio
to within our target range of eight to 12 times the amount of
our equity. As a result, the total amount of mortgage-backed
securities and repurchase agreement liabilities as of
December 31, 2003 were lower than they will be once our
portfolio is fully levered through additional repurchase
agreement liabilities and related mortgage-backed security
purchases.


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Item 6.Selected
Financial Data

The following selected financial data are derived
from our audited financial statements as of December 31,
2003 and for the period from April 26, 2003 through
December 31, 2003. The selected financial data should be
read in conjunction with the more detailed information contained
in Managements Discussion and Analysis of Financial
Condition and Results of Operations and the audited
financial statements and notes thereto that are included
elsewhere in this Form 10-K.

|                                                           |                                                                                         |                |   |            |  
|---------------------------------------------------------- | --------------------------------------------------------------------------------------- | -------------- | - | ---------- | -
|                                                           |                                                                                         | For the Period
|                                                           |                                                                                         | from April 26,
|                                                           |                                                                                         | 2003 through  
|                                                           |                                                                                         | December 31,  
|                                                           |                                                                                         | 2003          
|(dollars in thousands, except share and per share amounts) |                                                                                         |               
|Statement of Operations Data:                              |                                                                                         |                |   |           
|                                                           | Interest income                                                                         |                | $ | 22,654     |  
|                                                           | Interest expense                                                                        |                |   | 9,009      |  
|                                                           | Net interest income                                                                     |                |   | 13,645     |  
|                                                           | Losses on sale of mortgage-backed securities                                            |                |   | (7,831     | )
|                                                           | Expenses                                                                                |                |   | 3,053      |  
|                                                           | Net income                                                                              |                |   | 2,761      |  
|Per Common Share Data:                                     |                                                                                         |                |   |           
|                                                           | Net income  basic                                                                      |                | $ | 0.27       |  
|                                                           | Net income  diluted                                                                    |                |   | 0.27       |  
|                                                           | Cash distributions declared(1)                                                          |                |   | 0.95       |  
|                                                           | Book value (end of period)(2)                                                           |                |   | 11.38      |  
|                                                           | Common shares outstanding (end of period)                                               |                |   | 24,814,000 |  
|                                                           | Weighted-average shares outstanding 
    basic                                         |                |   | 10,139,280 |  
|                                                           | Weighted-average shares outstanding 
    diluted                                       |                |   | 10,139,811 |  
|Balance Sheet Data (end of period):                        |                                                                                         |                |   |           
|                                                           | Mortgage-backed securities available for sale, at
    fair value                        |                | $ | 352,123    |  
|                                                           | Mortgage-backed securities available for sale,
    pledged as collateral, at fair value |                |   | 1,809,822  |  
|                                                           | Total mortgage-backed securities available for
    sale, at fair value                  |                |   | 2,161,945  |  
|                                                           | Total assets                                                                            |                |   | 2,179,340  |  
|                                                           | Repurchase agreements                                                                   |                |   | 1,728,973  |  
|                                                           | Total liabilities                                                                       |                |   | 1,896,844  |  
|                                                           | Accumulated other comprehensive loss                                                    |                |   | (26,510    | )
|                                                           | Total stockholders equity                                                              |                |   | 282,496    |  
|Financial Ratios:                                          |                                                                                         |                |   |           
|                                                           | Leverage ratio (period end)(3)                                                          |                |   | 6.1        |  



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Cash distributions declared during the period
    from April 26, 2003 through December 31, 2003 were
    payable to stockholders of the 11,704,000 shares
    outstanding on each of the record dates prior to the completion
    of our initial public offering.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   
|(2) | Book value is calculated as total
    stockholders equity divided by the number of shares issued
    and outstanding as of December 31, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   
|(3) | Leverage is defined as total repurchase
    agreements divided by total stockholders equity. At
    December 31, 2003, substantially all of the net offering
    proceeds from our initial public offering had been used to
    purchase mortgage-backed securities. However, at
    December 31, 2003, we had not fully levered our portfolio
    to within our target range of eight to 12 times the amount
    of our equity. As a result, the total amount of mortgage-backed
    securities and repurchase agreement liabilities as of
    December 31, 2003 were lower than they will be once our
    portfolio is fully levered through additional repurchase
    agreement liabilities and related mortgage-backed security
    purchases.

31



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|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

The following discussion of our financial
condition and results of operations should be read in
conjunction with the financial statements and notes to those
statements included elsewhere in this document. This discussion
may contain forward-looking statements that involve risks and
uncertainties. The words believe,
expect, anticipate,
estimate, may, will, or
could and similar expressions or the negatives of
these words or phrases are intended to identify forward-looking
statements. As a result of many factors, such as those set forth
under Risk Factors and elsewhere in this document,
our actual results may differ materially from those anticipated
in such forward-looking statements.

General

Luminent Mortgage Capital, Inc. is a REIT
headquartered in San Francisco, California. We were
incorporated in April 2003 to invest primarily in
U.S. agency and other highly-rated, single-family,
adjustable-rate, hybrid adjustable-rate and fixed-rate
mortgage-backed securities, which we acquire in the secondary
market. Substantive operations began mid-June 2003, after
completing two private placements of our common stock. Our
strategy is to acquire mortgage-related assets, finance these
purchases in the capital markets and use leverage in order to
provide an attractive return on stockholders equity.
Through this strategy, we seek to earn income, which is
generated from the spread between the yield on our earning
assets and our costs, including the interest cost of the funds
we borrow. We have acquired and will seek to acquire additional
assets that will produce competitive returns, taking into
consideration the amount and nature of the anticipated returns
from the investment, our ability to pledge the investment for
secured, collateralized borrowings and the costs associated with
financing, managing, securitizing and reserving for these
investments.

Our business is affected by a variety of economic
and industry factors which management considers. The most
significant risk factors management considers while managing the
business which could have a material effect on the financial
condition and results of operations are:



| |   |                                                                                                                                                                                                                                                                                                           
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | interest rate mismatches between our
    adjustable-rate and hybrid adjustable-rate mortgage-backed
    securities and our borrowings used to fund our purchases of
    mortgage-backed securities;                                                                                                       
|
| |  | increasing or decreasing levels of prepayments on
    the mortgages underlying our mortgage-backed securities;                                                                                                                                                                                            
|
| |  | the potential for increased borrowing costs
    related to repurchase agreements;                                                                                                                                                                                                                         
|
| |  | interest rate caps related to our adjustable-rate
    and hybrid adjustable-rate mortgage-backed securities;                                                                                                                                                                                              
|
| |  | the overall leverage of our portfolio;                                                                                                                                                                                                                                                                    
|
| |  | our ability or inability to use derivatives to
    mitigate our interest rate and prepayment risks;                                                                                                                                                                                                       
|
| |  | the impact that increases in interest rates would
    have on our book value;                                                                                                                                                                                                                             
|
| |  | maintaining adequate borrowing capacity so that
    we can purchase mortgage-related assets and reach our desired
    amount of leverage. If we fail to obtain or renew sufficient
    funding on favorable terms or at all, we will be limited in our
    ability to acquire mortgage-related assets;    
|
| |  | possible market developments could cause our
    lenders to require us to pledge additional assets as collateral.
    If our assets are insufficient to meet the collateral
    requirements, we might be compelled to liquidate particular
    assets at inopportune times and at disadvantageous prices;
|
| |  | competition might prevent us from acquiring
    mortgage-backed securities at favorable yields, which would harm
    our results of operations;                                                                                                                                                           

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| |   |                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------
| |  | if we are disqualified as a REIT, we will be
    subject to tax as a regular corporation and face substantial tax
    liability; and
|
| |  | complying with REIT requirements might cause us
    to forego otherwise attractive opportunities.                                   

Management has established interest rate risk and
other policies for managing the portfolio of mortgage-backed
securities and the related borrowings outstanding. These
policies include, but are not limited to, evaluating the level
of risk we assume when purchasing adjustable-rate or hybrid
adjustable-rate mortgage-backed securities which are subject to
periodic and lifetime interest rate caps, matching the interest
rates on our assets and liabilities, acquiring new
mortgage-backed securities to replace prepaid securities,
purchasing mortgage-backed securities that we believe to have
favorable-risk adjusted expected returns relative to the market
interest rates at the time of purchase, borrowing between eight
and 12 times the amount of our stockholders equity,
entering into derivative transactions to protect us from rising
interest rates on our repurchase agreements, and monitoring our
qualification as a REIT.

Refer to the section titled Risk
Factors for additional discussion regarding these and
other risk factors which affect our business. Refer to the
section Interest Rate Risk of Item 7A,
Quantitative and Qualitative Disclosure About Market
Risk, for additional interest rate risk discussion.

Critical Accounting Policies

Our financial statements are prepared in
accordance with GAAP. These accounting principles require us to
make some complex and subjective decisions and assessments. Our
most critical accounting policies involve decisions and
assessments which could significantly affect our reported assets
and liabilities, as well as our reported revenues and expenses.
We believe that all of the decisions and assessments upon which
our financial statements are based were reasonable at the time
made based upon information available to us at that time. See
Note 2 to our financial statements included in Item 8
of this annual report on Form 10-K for a complete
discussion of our significant accounting policies. Management
has identified our most critical accounting policies to be the
following:



| |                                             
| | --------------------------------------------
| | Classifications of Investment
    Securities

Our investments in mortgage-backed securities are
classified as available-for-sale securities which are carried on
the balance sheet at their fair value. The classification of the
securities as available-for-sale results in changes in fair
value being recorded as adjustments to accumulated other
comprehensive loss, which is a component of stockholders
equity, rather than immediately through earnings. If
available-for-sale securities were classified as trading
securities, there could be substantially greater volatility in
earnings from period-to-period.



| |                                             
| | --------------------------------------------
| | Valuations of Mortgage-backed
    Securities

Our mortgage-backed securities have fair values
as determined by management with reference to price estimates
provided by independent pricing services and dealers in the
securities. Because the price estimates may vary to some degree
between sources, management must make certain judgments and
assumptions about the appropriate price to use to calculate the
fair values for financial reporting purposes. Different
judgments and assumptions could result in different
presentations of value.

When the fair value of an available-for-sale
security is less than amortized cost, management considers
whether there is an other-than-temporary impairment in the value
of the security. If, in managements judgment, an
other-than-temporary impairment exists, the cost basis of the
security is written down to the then-current fair value, and the
unrealized loss is transferred from accumulated other
comprehensive loss as an immediate reduction of current earnings
(as if the loss had been realized in the period of impairment).
The determination of other-than-temporary impairment is a
subjective process, and different judgments and assumptions
could affect the timing of loss realization.

33



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Management considers the following factors when
evaluating the securities for an other-than-temporary impairment:



| |   |                                                                                                                               
| | - | ------------------------------------------------------------------------------------------------------------------------------
| |  | the length of the time and the extent to which
    the market value has been less than the amortized cost;                    
|
| |  | whether the security has been downgraded by a
    rating agency; and                                                          
|
| |  | our intent to hold the security for a period of
    time sufficient to allow for any anticipated recovery in market
    value.

The determination of other-than-temporary
impairment is evaluated at least quarterly. If we determine an
impairment to be permanent we may need to realize a loss that
would have an impact on future income.



| |                            
| | ---------------------------
| | Interest Income Recognition

Interest income on our mortgage-backed securities
is accrued based on the actual coupon rate and the outstanding
principal amount of the underlying mortgages. Premiums and
discounts are amortized or accreted into interest income over
the lives of the securities using the effective yield method
adjusted for the effects of estimated prepayments based on
Statement of Financial Accounting Standards, or SFAS,
No. 91, Accounting for Nonrefundable Fees and Costs
Associated with Originating or Acquiring Loans and Initial
Direct Costs of Leases. If our estimate of prepayments is
incorrect, we may be required to make an adjustment to the
amortization or accretion of premiums and discounts that would
have an impact on future income.



| |                                                                           
| | --------------------------------------------------------------------------
| | Accounting for Derivative Financial
    Instruments and Hedging Activities

Our policies permit us to enter into derivative
contracts, including Eurodollar futures contracts and interest
rate swaps, as a means of mitigating our interest rate risk on
forecasted interest expense associated with the benchmark rate
on forecasted rollover/reissuance of repurchase agreements, or
hedged items, for a specified future time period.

At December 31, 2003, we have engaged in
short sales of Eurodollar futures contracts to mitigate our
interest rate risk for the specified future time period, which
is defined as the calendar quarter immediately following the
contract expiration date. The value of these futures contracts
is marked-to-market daily in our margin account with the
custodian. Based upon the daily market value of these futures
contracts, we either receive funds into, or wire funds into, our
margin account with the custodian to ensure that an appropriate
margin account balance is maintained at all times through the
expiration of the contracts.

These contracts, or hedge instruments, have been
designated as cash flow hedges and are evaluated at inception
and on an on-going basis in order to determine whether they
qualify for hedge accounting under SFAS No. 133, as
amended and interpreted. The hedge instrument must be highly
effective in achieving offsetting changes in the hedged item
attributable to the risk being hedged in order to qualify for
hedge accounting. In order to determine whether the hedge
instrument is highly effective, we use regression methodology to
assess the effectiveness of our hedging strategies.
Specifically, at the inception of each new hedge and on an
on-going basis, we assess effectiveness using ordinary
least squares regression to evaluate the correlation
between the rates consistent with the hedge instrument and the
underlying hedged items. A hedge instrument is highly effective
if the changes in the fair value of the derivative provide
offset of at least 80% and not more than 120% of the changes in
fair value or cash flows of the hedged item attributable to the
risk being hedged. The futures contracts are carried on the
balance sheet at fair value. Any ineffectiveness which arises
during the hedging relationship, is recognized in interest
expense during the period in which it arises. Prior to the end
of the specified hedge time period the effective portion of all
contract gains and losses (whether realized or unrealized) is
recorded in other comprehensive income or loss. Realized gains
and losses are reclassified into earnings as an adjustment to
interest expense during the specified hedge time period. For
REIT taxable net income purposes, realized gains and losses are
reclassified into earnings immediately upon contract expiration.

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We are not required to account for the futures
contracts using hedge accounting as described above. If we
decided not to designate the futures contracts as hedges and to
monitor their effectiveness as hedges, or if we entered into
other types of financial instruments that did not meet the
criteria to be designated as hedges, changes in the fair values
of these instruments would affect periodic earnings immediately.



| |                                              
| | ---------------------------------------------
| | Management Incentive Compensation
    Expense

The Management Agreement provides for the payment
of incentive compensation to the Manager if our financial
performance exceeds certain benchmarks. Incentive compensation
is calculated on a cumulative, quarterly basis for GAAP purposes
and on a stand-alone quarterly basis with an annual cumulative
reconciliation calculation for incentive compensation payment
purposes. During each quarter of the fiscal year, we will
calculate the incentive compensation expense quarterly, on a
cumulative basis, making any necessary adjustments for any
expensed amounts that were recognized in previous quarters. As a
result, if we experience poor quarterly performance in a
particular quarter and this causes the cumulative incentive
compensation expense for the current quarter to be lower than
the cumulative incentive compensation for the prior quarter, we
will record a negative incentive compensation expense in the
current quarter. The incentive compensation is payable one-half
in cash and one-half in the form of our restricted common stock.

For the first, second and third quarters of each
fiscal year, incentive compensation payments actually paid to
the Manager are calculated based upon the net income and
relevant performance thresholds solely for the applicable
quarter, and a cumulative calculation is performed at the end of
the fiscal year. As a result, during the first three quarters of
each fiscal year there will be differences between incentive
compensation expense, for GAAP purposes, and the incentive
compensation amounts actually paid to the Manager. Any
differences between these amounts will be reflected on the
balance sheet as a receivable due from or payable due to the
Manager. In addition, when each annual cumulative incentive
compensation calculation and reconciliation is performed, the
Manager may be required to return cash incentive compensation
payments earlier received or shares of common stock earlier
granted, as applicable, to it as part of its incentive
compensation payments for the first three quarters of the fiscal
year.

The cash portion of the incentive compensation is
accrued and expensed during the period for which it is
calculated and paid. We account for the restricted stock portion
of the incentive compensation in accordance with
SFAS No. 123, Accounting for Stock-based
Compensation, and related interpretations, and
EITF 96-18, Accounting for Equity Instruments That Are
Issued to Other Than Employees for Acquiring, or in Conjunction
with Selling, Goods or Services.

This restricted stock portion of the incentive
compensation will be paid or issued to the Manager on a
quarterly basis pursuant to the terms of the Management
Agreement. The number of shares issued is based on
(a) one-half of the total incentive compensation for the
period, divided by (b) the average of the closing prices of
the common stock over the 30 day period ending three days
prior to the grant date, less a fair market value discount
determined by our board of directors to account for the transfer
restrictions during the vesting period. During periods of lower
stock prices, we will issue more restricted common stock to the
Manager under the Management Agreement to pay for the same
amount of incentive compensation earned in periods that had
higher stock prices. Over the vesting period, any additional
shares issued would have a dilutive effect on book value and
earnings per share.

On the date of each restricted stock payment or
issuance to the Manager under the Management Agreement, the fair
market value of the common stock shall be recorded in the
stockholders equity section of our balance sheet as common
stock and additional paid-in capital. The corresponding portion
of any restricted stock payment that is not expensed will be
reflected in the stockholders equity section of our
balance sheet as deferred compensation. Each quarters
incentive compensation restricted stock payment or issuance to
the Manager will be divided into three tranches. The first
tranche will vest over a one-year period and be expensed over a
five-quarter period, beginning in the quarter in which it was
earned. The second tranche will vest over a two-year period and
be expensed over a nine-quarter period beginning in the quarter
in which it was earned. The third tranche will vest over a
three-year period and

35



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##### Table of Contents



be expensed over a thirteen-quarter period
beginning in the quarter in which it was earned. As a result of
this vesting schedule for the restricted stock issued to the
Manager, we will incur incentive compensation expense in each of
the periods following the issuance of the restricted stock over
a three-year period. We will continue to incur incentive
compensation expense related to each restricted stock payment,
even in subsequent periods in which the Manager did not earn
incentive compensation under the Management Agreement.


As the price of our common stock changes in
future periods, the fair value of the unvested portions of
shares paid to the Manager pursuant to the Management Agreement
shall be marked-to-market, with corresponding entries on the
balance sheet. The net effect of any mark-to-market adjustments
to the value of the unvested portions of the restricted stock
shall be expensed in future periods, on a ratable basis,
according to the remaining vesting schedules of each respective
tranche of restricted common stock. Accordingly, incentive
compensation expense related to the portion of the incentive
compensation paid to the Manager in each restricted stock
payment or issuance may be higher or lower from one reporting
period to the next, and may vary throughout the vesting period.
For example, future incentive compensation expense related to
previously issued but unvested restricted stock will be higher
during periods of increasing stock prices, and lower during
periods of decreasing stock prices. In addition, over the
vesting period for each restricted stock payment or issuance,
our stockholders equity will increase or decrease based
upon the current market price of our stock. As a result, this
will have the effect of increasing or decreasing our net worth,
the factor used in calculating the Managers base
management fee, and may increase or decrease the amount of base
management fees in future periods.

Pursuant to the Management Agreement, it is
possible for the Manager to earn incentive compensation each
quarter and, as a result, receive a restricted stock payment
each quarter. As the Manager is paid or issued multiple tranches
of restricted common stock for incentive compensation, we will
experience increasing management fee expense due to the
cumulative impact of multiple tranches and vesting schedules of
restricted stock payments, and the mark-to-market impact of the
unvested portions of these payments. This will be true even in
periods where there is little change in our income or stock
price.

We also pay an incentive fee, in the form of cash
and restricted stock, to our Chief Financial Officer, in
accordance with the terms of his employment agreement. The
incentive fee is accounted for in the same manner as the
incentive fee earned by the Manager.

Financial Condition

All of our assets at December 31, 2003 were
acquired with the proceeds of our June 2003 private placements
of 11,500,000 shares of our common stock, our December 2003
initial public offering of 13,110,000 shares of our common
stock and use of leverage. We received net proceeds after
offering costs of $159.7 million from the private placement
offerings, which closed on June 11, 2003 and June 19,
2003, and $157.0 million from the initial public offering,
which closed December 24, 2003.



| |                           
| | --------------------------
| | Mortgage-Backed Securities

At December 31, 2003, we held
$2.2 billion of mortgage-backed securities at fair value,
net of unrealized gains of $1.1 million and unrealized
losses of $27.4 million. As of December 31, 2003, all
of the mortgage-backed securities in our portfolio were
purchased at a premium to their par value and our portfolio had
a weighted-average amortized cost of 102.2.

Certain of the securities held at
December 31, 2003 are impaired as the fair value of the
securities is below amortized cost. At December 31, 2003,
our entire portfolio was invested in AAA-rated non-agency-backed
or agency-backed mortgage-backed securities. None of the
securities held had been downgraded by a credit rating agency
since their purchase. In addition, we intend to hold the
securities until maturity, allowing for the anticipated recovery
in fair value of the securities held. As such, we do not believe
any of securities held are other-than-temporarily impaired at
December 31, 2003.

36



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##### Table of Contents



The stated contractual final maturity of the
mortgage loans underlying our portfolio of mortgage-backed
securities ranges up to 30 years, however, the expected
maturity is subject to change based on the prepayments of the
underlying mortgage loans. The following table sets forth the
maturity dates, by year, and percentage composition related to
the assets that comprise our investment portfolio as of
December 31, 2003:

|                                                  |  |               |      |       |  |  |      |  
|------------------------------------------------- |  | ------------- | ---- | ----- |  |  | ---- | -
|                                                  |  | Average Final |      | % of 
|Asset                                             |  | Maturity      |      | Total
|                                                  |  |               |      |      
|Adjustable-Rate Mortgage-Backed Securities        |  |               | 2033 |       |  |  | 8.6  | %
|Hybrid Adjustable-Rate Mortgage-Backed Securities |  |               | 2033 |       |  |  | 88.9 | %
|Balloon Mortgage-Backed Securities                |  |               | 2008 |       |  |  | 2.5  | %
|Fixed-Rate Mortgage-Backed Securities             |  |               | N/A  |       |  |  | N/A  |  

Actual maturities of mortgage-backed securities
are generally shorter than stated contractual maturities. Actual
maturities of our mortgage-backed securities are affected by the
contractual lives of the underlying mortgages, periodic payments
of principal, and prepayments of principal.

The constant prepayment rate, or CPR, on our
mortgage-backed securities for the quarter ended
December 31, 2003 was 23%. CPR attempts to predict the
percentage of principal that will prepay over the next
12 months based on historical principal paydowns. As
interest rates have risen, the rate of refinancings has
declined, which we believe may result in lower rates of
prepayments and, as a result, a lower portfolio CPR.

As of December 31, 2003, the
weighted-average effective duration of the securities in our
overall investment portfolio, assuming constant prepayment rates
to the balloon or reset date, or the CPB duration, was
1.75 years. CPB is similar to CPR except that it also
assumes that the hybrid adjustable-rate mortgage-backed
securities prepay in full at their next reset date. As of
December 31, 2003, the mortgages underlying our hybrid
adjustable-rate mortgage-backed securities had fixed interest
rates for a weighted-average of approximately 43 months,
after which time the interest rates reset and become adjustable.
The average length of time until maturity of those mortgages was
30 years. Those mortgages are also subject to interest rate caps
that limit the amount that the applicable interest rate can
increase during any year, known as an annual cap, and through
the maturity of the applicable security, known as a lifetime
cap. As of December 31, 2003, the mortgages underlying our
hybrid adjustable-rate mortgage-backed securities had average
annual caps of 2.47% and average lifetime caps of 10.03%.

The following table summarizes our
mortgage-backed securities on December 31, 2003 according
to their estimated weighted-average life classifications:

|                                               |  |                |           |                |  |                  |           |  |  |  |      |  
|---------------------------------------------- |  | -------------- | --------- | -------------- |  | ---------------- | --------- |  |  |  | ---- | -
|                                               |  |                |           |                |  | Weighted-Average
|Weighted-Average Life                          |  | Fair Value     |           | Amortized Cost |  | Coupon          
|                                               |  |                |           |                |  |                 
|                                               |  | (In thousands) |           | (In thousands) |  |                 
|Less than one year                             |  | $              | 299,685   |                |  | $                | 304,556   |  |  |  | 4.07 | %
|Greater than one year and less than five years |  |                | 1,829,471 |                |  |                  | 1,850,899 |  |  |  | 4.09 |  
|Greater than five years                        |  |                | 32,789    |                |  |                  | 32,843    |  |  |  | 3.96 |  
|                                               |  |                |           |                |  |                  |           |  |  |  |      |  
|Total                                          |  | $              | 2,161,945 |                |  | $                | 2,188,298 |  |  |  | 4.09 | %
|                                               |  |                |           |                |  |                  |           |  |  |  |      |  

The weighted-average lives of the mortgage-backed
securities at December 31, 2003 in the table above are
based upon data provided through a subscription-based financial
information service provided by a major investment bank,
assuming constant principal prepayment rates to the balloon or
reset date for each security. At December 31, 2003, the
weighted-average lives were calculated using estimated
prepayment speeds or actual prepayment speed history. The
weighted-average lives for some of the mortgage-backed
securities included in the table above were estimated using
expected prepayment speeds for pools, since certain pools were
new issues and did not have historical performance data
available. The prepayment model considers current yield, forward
yield, steepness of the yield curve, current mortgage rates,
mortgage rate of the outstanding loan, loan age, margin and
volatility.

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The actual weighted-average lives of the
mortgage-backed securities in our investment portfolio could be
longer or shorter than the estimates in the tables above
depending on the actual prepayment rates experienced over the
life of the applicable securities and is sensitive to changes in
both prepayment rates and interest rates.



| |                  
| | -----------------
| | Equity Securities

Our investment policies allow us to acquire a
limited amount of equity securities, including common and
preferred shares issued by other real estate investment trusts.
At December 31, 2003, we did not hold any equity securities.



| |                                   
| | ----------------------------------
| | Unsettled Securities
    Purchases

At December 31, 2003, we had unsettled
securities purchases of $156.1 million which subsequently
settled in January 2004. Of the $156.1 million of unsettled
securities purchases, $59.8 million are related to to
be announced, or TBA, mortgage-backed securities.



| |             
| | ------------
| | Other Assets

We had other assets of $10.2 million at
December 31, 2003. Other assets consist primarily of
interest receivable of $7.3 million and principal
receivable of $2.3 million.



| |                    
| | -------------------
| | Hedging Instruments

There can be no assurance that our hedging
activities will have the desired beneficial impact on our
results of operations or financial condition. Moreover, no
hedging activity can completely insulate us from the risks
associated with changes in interest rates and prepayment rates.

Hedging involves risk and typically involves
costs, including transaction costs. The costs of hedging
increase dramatically as the period covered by the hedging
increases and during periods of rising and volatile interest
rates. We may increase our hedging activity and, thus, increase
our hedging costs during such periods when interest rates are
volatile or rising. We generally intend to hedge as much of the
interest rate risk as our manager determines is in the best
interest of our stockholders, after considering the cost of such
hedging transactions and our desire to maintain our status as a
REIT. Our policies do not contain specific requirements as to
the percentages or amount of interest rate risk that our manager
is required to hedge.

At December 31, 2003, we have engaged in
short sales of Eurodollar futures contracts as a means of
mitigating our interest rate risk on forecasted interest expense
associated with the benchmark rate on forecasted
rollover/reissuance of repurchase agreements, or hedged item,
for a specified future time period, which is defined as the
calendar quarter immediately following the contract expiration
date. We sold short 2,090 Eurodollar futures contracts, which
expire in March 2004, June 2004 and September 2004, with a
notional amount totaling $2.1 billion. The value of these
futures contracts is marked-to-market daily in our margin
account with the custodian. Based upon the daily market value of
these futures contracts, we either receive funds into, or wire
funds into, our margin account with the custodian to ensure that
an appropriate margin account balance is maintained at all times
through the expiration of the contracts. At December 31,
2003, the unrealized loss on the Eurodollar futures contracts
was $157 thousand.



| |            
| | -----------
| | Liabilities

We have entered into repurchase agreements to
finance some of our acquisitions of mortgage-backed securities.
None of the counterparties to these agreements are affiliates of
the Manager or us. These agreements are secured by our
mortgage-backed securities and bear interest rates that have
historically moved in close relationship to LIBOR. As of
December 31, 2003 we had established 17 borrowing
arrangements with various investment banking firms and other
lenders, 12 of which were in use on December 31, 2003.

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At December 31, 2003, we had outstanding
$1.7 billion of repurchase agreements with a
weighted-average current borrowing rate of 1.19%,
$337.3 million of which matures within 30 days,
$281.9 million of which matures between 31 and 90 days
and $1.1 billion of which matures in greater than
90 days. It is our present intention to seek to renew these
repurchase agreements as they mature under the then-applicable
borrowing terms of the counterparties to our repurchase
agreements. At December 31, 2003, the repurchase agreements
were secured by mortgage-backed securities with an estimated
fair value of $1.8 billion and had a weighted-average
maturity of 145 days. The net amount at risk, defined as
fair value of securities sold, plus accrued interest income,
minus repurchase agreement liabilities, plus accrued interest
expense, with all counterparties was $83.2 million.

After consideration of the duration on our
Eurodollar futures contracts, our weighted-average maturity of
our total liabilities was 255 days.

We had $167.9 million of other liabilities
at December 31, 2003. Other liabilities consisted primarily
of $156.1 million of unsettled securities purchases,
$5.3 million of cash distribution payable,
$3.8 million of accrued interest expense on repurchase
agreements, $1.4 million of accounts payable and accrued
expenses, and $1.1 million of management fee payable,
incentive fee payable and other related party liabilities.

We have a margin lending facility with our
primary custodian from which we may borrow money in connection
with the purchase or sale of securities. The terms of the
borrowings, including the rate of interest payable, are agreed
to with the custodian for each amount borrowed. Borrowings are
repayable immediately upon demand of the custodian. At
December 31, 2003, there were no outstanding borrowings
under the margin lending facility.



| |                     
| | --------------------
| | Stockholders Equity

Stockholders equity at December 31,
2003 was $282.5 million and included $26.3 million of
unrealized losses on mortgage-backed securities
available-for-sale and $157 thousand of unrealized losses on
cash flow hedges presented as accumulated other comprehensive
loss.

Average stockholders equity for the period
from June 11, 2003, commencement of operations, through
December 31, 2003 was $128.4 million. Return on
average equity was 3.85% for the period from June 11, 2003,
commencement of operations, through December 31, 2003.
Because of the timing of our initial investment of portfolio
assets (investment activities began on June 11, 2003, the
first security purchase settled on June 16, 2003, and the
remainder settled through July 31, 2003), interest income
for the period from June 11, 2003 through December 31,
2003 was lower than would be expected for a typical full period,
both in an absolute sense and also relative to the average net
invested assets for the period. During the period, the
U.S. bond markets also experienced dramatic price and yield
volatility. Increasing interest rates caused the overall market
value of our portfolio to decrease, and our leverage, defined as
our total debt divided by stockholders equity, to increase
beyond our desired range. In order to deleverage our portfolio
we sold securities at a loss. In addition, operating expenses
were high in proportion to gross interest income and expense and
to net interest income as compared to expectations for full
periods of operations because of the costs of start-up
operations. As such, return on average equity was lower as
compared to expectations for full periods of operations.

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Our book value at December 31, 2003 was as
follows:

|                                                                                                                 |  |                           |         |              |  |   |       | 
|---------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ------- | ------------ |  | - | ----- | 
|                                                                                                                 |  | Total                     |         |             
|                                                                                                                 |  | Stockholders             |         | Book Value  
|                                                                                                                 |  | Equity                    |         | per Share(1)
|                                                                                                                 |  |                           |         |             
|                                                                                                                 |  |                          
|                                                                                                                 |  | (Dollars in thousands,   
|                                                                                                                 |  | except per share amounts)
|Total stockholders equity                                                                                       |  | $                         | 282,496 |              |  | $ | 11.38 | 
|Accumulated other comprehensive loss on
    mortgage-backed securities                                           |  |                           | 26,353  |              |  |   | 1.07  | 
|                                                                                                                 |  |                           |         |              |  |   |       | 
|Total stockholders equity, excluding
    accumulated other comprehensive loss on mortgage-backed
    securities |  | $                         | 308,849 |              |  | $ | 12.45 | 
|                                                                                                                 |  |                           |         |              |  |   |       | 



---



|    |                                                                
|--- | ---------------------------------------------------------------
|(1) | Based on 24,814,000 shares outstanding on
    December 31, 2003

Management believes that total stockholders
equity excluding accumulated other comprehensive loss on
mortgage-backed securities is a useful measure to investors
because book value unadjusted for temporary declines in the fair
values of securities more closely represents the cost basis of
our invested assets, net of our leverage, which is the basis for
our net interest income and our distributions to stockholders
under the tax code governing REIT distributions.

Results of Operations

For the period from April 26, 2003 through
December 31, 2003, net income was $2.8 million or
$0.27 per weighted-average share (basic and diluted). For
the same period, interest income, net of premium amortization,
was approximately $22.6 million, and was primarily earned
from investments in mortgage-backed securities. Interest expense
on short-term borrowings was $9.0 million. Because of the
timing of our initial investment of portfolio assets (investment
activities began on June 11, 2003), interest income for the
period from April 26, 2003 through December 31, 2003
was substantially lower than would be expected for a typical
full period, both in an absolute sense and also relative to the
average net invested assets for the period. In addition,
prepayment activity declined due to the changing interest rate
environment and resulted in decreased premium amortization and
increased yield on average earning assets.

For the quarter ended December 31, 2003, the
weighted-average yield on average earning assets, net of
amortization of premium was 2.81% and the weighted-average
interest rate on our repurchase agreement liabilities was 1.20%
resulting in a net interest margin of 1.61%. Our net interest
margin improved during the course of the fourth quarter. For the
period from April 26, 2003 through December 31, 2003,
net interest margin and its components are not meaningful due to
the timing of our initial investments and related borrowings.

Included in net income for the period from
April 26, 2003 through December 31, 2003 are net
losses on sales of mortgage-backed securities of
$7.8 million which occurred during the quarter ended
September 30, 2003. Between June 30, 2003 and
mid-August 2003, the U.S. bond markets experienced dramatic
price and yield volatility. Increasing interest rates caused the
overall market value of our portfolio to decrease and our
leverage (defined as our total debt divided by
stockholders equity) to increase beyond managements
desired range. To reduce leverage, we sold securities in
mid-August totaling $130.7 million and realized a loss of
$2.3 million. In an attempt to protect our portfolio from
further increases in interest rates, we sold short
$200 million of TBA mortgage securities. Interest rates
subsequently declined, and we closed out this short position in
the month of September for a total realized loss of
$5.7 million. During the third quarter, we also
simultaneously sold and purchased securities totaling
$215.9 million and $215.7 million, respectively, that
resulted in a realized gain on sale of $0.2 million. We did
not sell any mortgage-backed securities during the period from
April 26 through June 30, 2003 or during the quarter
ended December 31, 2003, therefore, there were no gains or
losses on sales of securities for these periods. Although we
generally intend to hold our investment securities to maturity,
the Manager may determine at

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some time before they mature that it is in our
interest to sell them and purchase securities with other
characteristics. In that event, our earnings will be affected by
realized gains or losses.


Operating expenses for the period from
April 26, 2003 through December 31, 2003 were
$3.1 million. Operating expenses were high in proportion to
gross interest income and expense and to net interest income as
compared to expectations for full periods of operations because
of the costs of start-up operations.

Base management fees to the Manager under the
Management Agreement, which were $901 thousand for the period
from April 26, 2003 through December 31, 2003, are
based on a percentage of our average net worth. Average
net worth for these purposes is calculated on a monthly
basis and equals the difference between the aggregate book value
of our consolidated assets prior to accumulated depreciation and
other non-cash items, including the fair market value adjustment
on mortgage-backed securities, minus the aggregate book value of
our consolidated liabilities.

Incentive fee expense to related parties for the
period from April 26, 2003 through December 31, 2003
was $980 thousand. Incentive compensation is earned by related
parties when REIT taxable net income (before deducting incentive
compensation, net operating losses and certain other items)
relative to the average net invested assets for the period, as
defined in the Management Agreement, exceeds the threshold
return taxable income that would have produced an
annualized return on equity equal to the sum of the 10-year
U.S. Treasury rate plus 2.0% for the same period. REIT
taxable net income (before deducting incentive compensation, net
operating losses and certain other items) for the period from
April 26, 2003 through December 31, 2003 was
$11.7 million and was greater than the threshold
return taxable income of $5.6 million for the same
period. Incentive compensation earned by the Manager during the
period from April 26, 2003 through December 31, 2003
was $1.2 million, of which $613 thousand was waived by
the Manager for the quarter ended September 30, 2003.

For the quarter ended December 31, 2003,
total incentive compensation expense to the Manager was $606
thousand, one-half payable in cash and one-half payable in the
form of the Companys common stock as described above. The
cash portion of the incentive fee of $303 thousand for the
quarter ended December 31, 2003 was expensed in that period
as well as 15.2% of the restricted stock portion of the
incentive fees, or $46 thousand. The remaining incentive
fee for the quarter ended December 31, 2003 of $30 thousand
was earned by the Companys Chief Financial Officer, in
accordance with the terms of his employment agreement. This
portion of the incentive fee is also payable one-half in cash
and one-half in the form of a restricted stock award under the
Companys 2003 Stock Incentive Plan. The shares are payable
and vest over the same vesting schedule as the stock issued to
the Manager. The cash portion of the incentive fee of
$15 thousand for the quarter ended December 31, 2003
was expensed in that period as well as 15.2% of the restricted
stock portion of the incentive fees, or $3 thousand.

We did not pay incentive compensation to the
Manager for the quarter ended September 30, 2003 or the
period from April 26, 2003 to June 30, 2003. The
incentive compensation expense earned by the Manager for the
quarter ended September 30, 2003 of $613 thousand was
waived by the Manager on a one-time basis only due to the net
loss we reported during that same period. The waived incentive
fee was accounted for as incentive fee expense and a capital
contribution as of September 30, 2003. We do not expect the
Manager to waive incentive compensation in the future. REIT
taxable net income (before deducting incentive compensation, net
operating losses and certain other items) for the period from
April 26, 2003 through June 30, 2003, was $298 and was
less than the threshold return taxable income of
$426 and, therefore, no incentive fee was earned by the Manager
or paid by us. No incentive compensation was earned or paid to
the Chief Financial Officer for the period from April 26,
2003 to September 30, 2003.

Professional services expense for the period from
April 26, 2003 through December 31, 2003 of
$477 thousand includes both legal and accounting services
provided to us. We experienced relatively higher levels of
professional service expenses during our stabilization period as
a public company. Included in this balance are organization
costs of $163 thousand, and costs related to the filing of our
resale shelf registration statement totaling $44 thousand.
The insurance expense for the same period of $291 thousand

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represents amortization of prepaid
directors and officers insurance. Custody expense of
$115 thousand for the period from April 26, 2003
through December 31, 2003 includes the services provided by
our primary custodian. These expenses may vary based on levels
of activity within the portfolio. Included in the other general
and administrative expenses of $73 thousand for the period
from April 26, 2003 through December 31, 2003 are
costs related to the filing of our resale shelf registration
statement totaling $27 thousand.


REIT taxable net income is calculated according
to the requirements of the Internal Revenue Code, rather than
GAAP. The following table reconciles GAAP net income to REIT
taxable net income for the period from April 26, 2003
through December 31, 2003 (in thousands):

|                                |                                                                           |                                    |        |       |       | 
|------------------------------- | ------------------------------------------------------------------------- | ---------------------------------- | ------ | ----- | ----- | 
|GAAP net income                 |                                                                           | $                                  | 2,761  |      
|Adjustments to GAAP net income: |                                                                           |                                    |        |      
|                                | Addback of organizational costs expensed during
    the period            |                                    |        | 163   |      
|                                | Amortization of organizational costs for tax
    purposes                 |                                    |        | (18   | )    
|                                | Addback of net capital losses in the period                               |                                    |        | 7,831 |      
|                                | Addback waived incentive fee for the quarter
    ended September 30, 2003 |                                    |        | 613   |      
|                                | Addback of stock compensation expense for
    incentive fee               |                                    |        | 48    |      
|                                | Addback of stock compensation expense for
    unvested options            |                                    |        | 3     |      
|                                |                                                                           |                                    |        |      
|                                |                                                                           | Net adjustments to GAAP net income |        |       | 8,640 | 
|                                |                                                                           |                                    |        |      
|REIT taxable net income         |                                                                           | $                                  | 11,401 |      
|                                |                                                                           |                                    |        |      

We believe that the presentation of our REIT
taxable net income is useful to investors because it is directly
related to the distributions we are required to make in order to
retain our REIT status and to the calculations of the incentive
compensation payable to related parties (before deducting
incentive compensation, net operating losses and certain other
items). There are limitations associated with REIT taxable net
income. For example, this measure does not reflect net capital
losses during the period and, thus, by itself is an incomplete
measure of our financial performance over any period. As a
result, our REIT taxable net income should be considered in
addition to, and not as a substitute for, our GAAP-based net
income as a measure of our financial performance.

Contractual Obligations and
Commitments

As of December 31, 2003, we had entered into
a Management Agreement with our Manager. See Note 7 to the
financial statements for significant terms of the Management
Agreement.

Off-Balance Sheet Arrangements

Since inception, we have not maintained any
relationships with unconsolidated entities or financial
partnerships, such as entities often referred to as structured
finance or special purpose entities, established for the purpose
of facilitating off-balance sheet arrangements or other
contractually narrow or limited purposes. Further, we have not
guaranteed any obligations of unconsolidated entities nor do we
have any commitment or intent to provide additional funding to
any such entities. Accordingly, we are not materially exposed to
any market, credit, liquidity or financing risk that could arise
if we had engaged in such relationships.

Liquidity and Capital Resources

Our primary source of funds as of
December 31, 2003 consisted of repurchase agreements
totaling $1.7 billion with a weighted-average current
borrowing rate of 1.19% which we used to finance acquisition of
mortgage-related assets. We expect to continue to borrow funds
in the form of repurchase agreements. As of December 31,
2003 we had established 17 borrowing arrangements with
various investment banking firms and other lenders, 12 of which
were in use on December 31, 2003. Increases in short-term
interest

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rates could negatively impact the valuation of
our mortgage-related assets, which could limit our borrowing
ability or cause our lenders to initiate margin calls. Amounts
due upon maturity of our repurchase agreements will be funded
primarily through the rollover/reissuance of repurchase
agreements and monthly principal and interest payments received
on our mortgage-backed securities. We generally seek to borrow
between eight and 12 times the amount of our equity. Our
leverage ratio at December 31, 2003 was 6.1. At
December 31, 2003, substantially all of the net offering
proceeds from our initial public offering had been used to
purchase mortgage-backed securities. However, at
December 31, 2003, we had not fully levered our portfolio
to within our target range of eight to 12 times the amount
of our equity. As a result, the total amount of mortgage-backed
securities and repurchase agreement liabilities as of
December 31, 2003 were lower than they will be once our
portfolio is fully levered through additional repurchase
agreement liabilities and related mortgage-backed security
purchases.


We have a margin lending facility with our
primary custodian from which we may borrow money in connection
with the purchase or sale of securities. The terms of the
borrowings, including the rate of interest payable, are agreed
to with the custodian for each amount borrowed. Borrowings are
repayable immediately upon demand of the custodian. At
December 31, 2003, there were no outstanding borrowings
under the margin lending facility.

For liquidity, we also rely on the cash flow from
operations, primarily monthly principal and interest payments to
be received on our mortgage-backed securities, as well as any
primary securities offerings authorized by our board of
directors.

On November 17, 2003, we paid a cash
distribution of $0.50 per share to our stockholders of
record on October 21, 2003. On January 28, 2004, we
paid a cash distribution of $0.45 per share to our
stockholders of record on December 11, 2003. Both of these
distributions are taxable dividends, and neither of these
distributions are considered return of capital. The
distributions were funded with cash flow from our ongoing
operations, including principal and interest payments received
on our mortgage-backed securities. We did not distribute
$282 thousand of our REIT taxable net income for the period
from April 26, 2003 through December 31, 2003. We
intend to declare a spillback distribution in this amount during
2004.

We believe that equity capital, combined with the
cash flow from operations and the utilization of borrowings,
will be sufficient to enable us to meet anticipated liquidity
requirements. However, an increase in prepayment rates
substantially above our expectations could cause a liquidity
shortfall. If our cash resources are at any time insufficient to
satisfy our liquidity requirements, we may be required to
liquidate mortgage-backed securities or sell debt or additional
equity securities. If required, the sale of mortgage-backed
securities at prices lower than the carrying value of such
assets would result in losses and reduced income.

We intend to increase our capital resources by
making additional offerings of equity and debt securities,
possibly including classes of preferred stock, common stock,
commercial paper, medium-term notes, collateralized mortgage
obligations and senior or subordinated notes. Such financing
will depend on market conditions for capital raises and for the
investment of any proceeds. All debt securities, other
borrowings, and classes of preferred stock will be senior to the
common stock in a liquidation of our Company.

Inflation

Virtually all of our assets and liabilities are
financial in nature. As a result, interest rates and other
factors influence our performance far more so than does
inflation. Changes in interest rates do not necessarily
correlate with inflation rates or changes in inflation rates.
Our financial statements are prepared in accordance with
accounting principles generally accepted in the United States
and our distributions are determined by our board of directors
based primarily by our net income as calculated for tax
purposes; in each case, our activities and balance sheet are
measured with reference to historical cost and or fair market
value without considering inflation.

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Risk Factors

Risks Related to Our Business



| |                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have a limited operating history and
    might not be able to operate our business or implement our
    operating policies and strategies successfully.

We began operations in June of 2003, and we have
a limited operating history. The results of our operations will
depend on many factors, including the availability of
opportunities for the acquisition of mortgage-related assets,
the level and volatility of interest rates, readily accessible
short-and long-term funding alternatives in the financial
markets and economic conditions. Moreover, delays in investing
our net proceeds of our initial public offering may cause our
performance to be weaker than other fully invested mortgage
REITs pursuing comparable investment strategies. You will not
have the opportunity to evaluate the manner in which we invest
or the economic merits of particular assets to be acquired.
Furthermore, we face the risk that we might not successfully
operate our business or implement our operating policies and
strategies as described in this annual report on Form 10-K.



| |                                                                                                                                                                                                                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our investment guidelines permit us to
    invest up to 10% of our assets in unrated mortgage-related
    assets, including mortgage-backed securities rated below
    investment-grade, which carry a greater likelihood of default or
    rating downgrade than investments in investment-grade
    mortgage-backed securities and may cause us to suffer
    losses.

Our asset acquisition policy provides us with the
ability to acquire significant amounts of lower credit quality
mortgage-related assets, including mortgage-backed securities
that are not rated at least investment grade by at least one
nationally-recognized statistical rating organization. Under our
policy, up to 10% of our total assets may be non-investment
grade mortgage-backed securities or other investments such as
leveraged mortgage derivative securities, shares of other REITs,
mortgage loans or other mortgage-related investments. If we
acquire non-investment-grade mortgage-backed securities, we are
more likely to incur losses because the mortgages underlying
those securities are made to borrowers possessing lower-quality
credit. While all agency certificates are subject to a risk of
default, that risk is greater with non-investment grade
mortgage-backed securities. In addition, the rating agencies are
more likely to downgrade the credit quality of those securities,
which would reduce the value of those securities.



| |                                                                                                                                                                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Interest rate mismatches between our
    adjustable-rate and hybrid adjustable-rate mortgage-backed
    securities and the borrowings used to fund our purchases of such
    mortgage-backed securities might reduce our net income or result
    in a loss during periods of changing interest
    rates.

We invest primarily in adjustable-rate and hybrid
adjustable-rate mortgage-backed securities. The mortgages
underlying adjustable-rate mortgage-backed securities have
interest rates that reset periodically, typically every six
months or on an annual basis, based upon market-based indices of
interest rates such as U.S. Treasury bonds or LIBOR. The
mortgages underlying hybrid adjustable-rate mortgage-backed
securities have interest rates that are fixed for the first few
years of the loan  typically three, five, seven or
10 years  and thereafter their interest rates
reset periodically similar to the mortgages underlying
adjustable-rate mortgage-backed securities. We have funded our
acquisitions and expect to fund our future acquisitions of
adjustable-rate and hybrid adjustable-rate mortgage-backed
securities in part with borrowings that have interest rates
based on indices and repricing terms similar to, but with
shorter maturities than, the interest rate indices and repricing
terms of the adjustable-rate and hybrid adjustable-rate
mortgage-backed securities. On December 31, 2003, 97.5% of
our investment portfolio was invested in adjustable-rate or
hybrid adjustable-rate mortgage-backed securities having a
weighted-average term to next rate adjustment of approximately
40 months, while our borrowings had a weighted-average term
of approximately 145 days. After consideration of the
duration on our Eurodollar futures contracts, our
weighted-average maturity was 255 days. The phrase
weighted average term to next rate adjustment refers
to the average of the periods of time that must elapse before
the interest rates adjust for all of the mortgages underlying
our adjustable-rate and hybrid adjustable-rate mortgage-backed
securities in our portfolio, which average is weighted in
proportion to the book values of the applicable securities.
During

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periods of changing interest rates, this interest
rate mismatch between our assets and liabilities could reduce or
eliminate our net income and distributions to our stockholders
and could cause us to suffer a loss.


Accordingly, in a period of rising interest
rates, we could experience a decrease in, or elimination of, net
income or a net loss because the interest rates on our
borrowings adjust faster than the interest rates on our
adjustable-rate mortgage-backed securities.



| |                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Increased levels of prepayments on the
    mortgages underlying our mortgage-backed securities might
    decrease our net interest income or result in a net
    loss.

The mortgage-backed securities that we acquire
generally represent interests in pools of mortgage loans. The
principal and interest payments we receive from our
mortgage-backed securities are generally funded by the payments
that mortgage borrowers make on those underlying mortgage loans.
When borrowers pre-pay their mortgage loans sooner than
expected, corresponding prepayments on the mortgage-backed
securities occur sooner than expected by the marketplace.
Sooner-than-expected prepayments could harm our results of
operations in the following ways, among others:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We seek to purchase mortgage-backed securities
    that we believe to have favorable risk-adjusted expected returns
    relative to market interest rates at the time of purchase. If
    the coupon interest rate for a mortgage- backed security is
    higher than the market interest rate at the time it is
    purchased, then that mortgage-backed security will be acquired
    at a premium to its par value. In accordance with applicable
    accounting rules, we are required to amortize any premiums or
    discounts related to our mortgage-backed securities over their
    expected terms. The amortization of a premium reduces interest
    income, while the amortization of a discount increases interest
    income. The expected terms for mortgage-backed securities are a
    function of the prepayment rates for the mortgages underlying
    the mortgage-backed securities. Mortgage-backed securities that
    are at a premium to their par value are more likely to
    experience prepayment of some or all of their principal through
    refinancings. If the mortgages underlying our premium
    mortgage-backed securities are prepaid in whole or in part more
    quickly than their respective maturity dates, then we must also
    amortize their respective premiums more quickly, which would
    decrease our net interest income and harm our profitability.
|
| |  | A substantial portion of our adjustable-rate
    mortgage-backed securities may bear interest at rates that are
    lower than their fully-indexed rates, which refers
    to their applicable index rates plus a margin. If an
    adjustable-rate mortgage-backed security is prepaid prior to or
    soon after the time of adjustment to a fully-indexed rate, we
    will have held that mortgage-backed security while it was less
    profitable and lost the opportunity to receive interest at the
    fully-indexed rate over the remainder of its expected life.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|
| |  | If we are unable to acquire new mortgage-backed
    securities to replace the prepaid mortgage-backed securities,
    our financial condition, results of operations and cash flow may
    suffer and we could incur losses.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

Prepayment rates generally increase when interest
rates fall and decrease when interest rates rise, but changes in
prepayment rates are difficult to predict. Prepayment rates also
may be affected by other factors, including, without limitation,
conditions in the housing and financial markets, general
economic conditions and the relative interest rates on
adjustable-rate and fixed-rate mortgage loans. While we seek to
minimize prepayment risk, we must balance prepayment risk
against other risks and the potential returns of each investment
when selecting investments. No strategy can completely insulate
us from prepayment or other such risks.

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| |                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------
| | We may incur increased borrowing costs
    related to repurchase agreements that would harm our results of
    operations.

Our borrowing costs under repurchase agreements
are generally adjustable and correspond to short-term interest
rates, such as LIBOR or a short-term Treasury index, plus or
minus a margin. The margins on these borrowings over or under
short-term interest rates may vary depending upon a number of
factors, including, without limitation:



| |   |                                                               
| | - | --------------------------------------------------------------
| |  | the movement of interest rates;                               
|
| |  | the availability of financing in the
    market; and          
|
| |  | the value and liquidity of our mortgage-backed
    securities.

Most of our borrowings are collateralized
borrowings in the form of repurchase agreements. If the interest
rates on these repurchase agreements increase, our results of
operations will be harmed and we may have losses.



| |                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Interest rate caps related to our
    adjustable-rate and hybrid adjustable-rate mortgage-backed
    securities may reduce our income or cause us to suffer a loss
    during periods of rising interest rates.

The mortgages underlying our adjustable-rate and
hybrid adjustable-rate mortgage-backed securities are typically
subject to periodic and lifetime interest rate caps. Periodic
interest rate caps limit the amount that the interest rate of a
mortgage can increase during any given period. Lifetime interest
rate caps limit the amount an interest rate can increase through
the maturity of a mortgage. As of December 31, 2003, 97.5%
of our mortgage-backed securities were based on adjustable-rate
or hybrid adjustable-rate mortgages, substantially all of which
were subject to interest rate caps. The percentage of
adjustable-rate and hybrid adjustable-rate mortgage-backed
securities in our investment portfolio which are subject to
periodic interest rate caps every six months or annually were
16.6% and 80.9%, respectively.

Our borrowings are not subject to similar
restrictions. The periodic adjustments to the interest rates of
the mortgages underlying our adjustable-rate and hybrid
adjustable-rate mortgage-backed securities are based on changes
in an objective index. Substantially all of the mortgages
underlying our adjustable-rate and hybrid adjustable-rate
mortgage-backed securities adjust their interest rates based on
one of two main indices, the U.S. Treasury index, a monthly
or weekly average yield of benchmark U.S. Treasury
securities as published by the Federal Reserve Board, or LIBOR,
the interest rate that banks in London offer for deposits in
London of U.S. dollars. The percentages of the mortgages
underlying the adjustable-rate and hybrid adjustable-rate
mortgage-backed securities in our investment portfolio as of
December 31, 2003 with interest rates that reset based on
the U.S. Treasury or LIBOR indices were 39.1% and 58.4%,
respectively.

Accordingly, in a period of rapidly increasing
interest rates, the interest rates paid on our borrowings could
increase without limitation while interest rate caps could limit
the increases in the yields on our adjustable-rate and hybrid
adjustable-rate mortgage-backed securities. This problem is
magnified for adjustable-rate and hybrid adjustable-rate
mortgage-backed securities that are not fully indexed. Further,
some of the mortgages underlying our adjustable-rate and hybrid
adjustable-rate mortgage-backed securities may be subject to
periodic payment caps that result in a portion of the interest
being deferred and added to the principal outstanding. As a
result, we may receive less cash income on adjustable-rate and
hybrid adjustable-rate mortgage-backed securities than we need
to pay interest on our related borrowings. These factors could
reduce our net interest income or cause us to suffer a net loss.



| |                                                                                                                                               
| | ----------------------------------------------------------------------------------------------------------------------------------------------
| | We might experience reduced net interest
    income or a loss from holding fixed-rate investments during
    periods of rising interest rates.

A significant portion of our investment portfolio
consists of hybrid adjustable-rate mortgage-backed securities.
As of December 31, 2003, 88.9% of our investment portfolio
consisted of hybrid adjustable-rate mortgage-backed securities.
We may also invest in fixed-rate mortgage-backed securities from
time to

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time, however, as of December 31, 2003, none
of our portfolio consisted of fixed-rate mortgage-backed
securities. We fund our acquisition of fixed-rate
mortgage-backed securities, including those based on balloon
maturity and hybrid adjustable-rate mortgages, in part with
short-term repurchase agreements and term loans. During periods
of rising interest rates, our costs associated with borrowings
used to fund the acquisition of fixed-rate mortgage-backed
securities are subject to increases while the income we earn
from these assets remains substantially fixed. This would reduce
and could eliminate the net interest spread between the
fixed-rate mortgage-backed securities that we purchase and our
borrowings used to purchase them, which would reduce our net
interest income and could cause us to suffer a loss.




| |                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our leverage strategy increases the risks
    of our operations, which could reduce our net income and the
    amount available for distributions or cause us to suffer a
    loss.

We generally seek to borrow between eight and 12
times the amount of our equity, although at times our borrowings
may be above or below this amount. We incur this indebtedness by
borrowing against a substantial portion of the market value of
our mortgage-backed securities. Our total indebtedness, however,
is not expressly limited by our policies and will depend on our
and our prospective lenders estimate of the stability of
our portfolios cash flow. We face the risk that we might
not be able to meet our debt service obligations or a
lenders margin requirements from our income and, to the
extent we cannot, we might be forced to liquidate some of our
assets at disadvantageous prices. Our use of leverage amplifies
the risks associated with other risk factors, which could reduce
our net income and the amount available for distributions or
cause us to suffer a loss. For example:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | A majority of our borrowings are secured by our
    mortgage-backed securities, generally under repurchase
    agreements. A decline in the market value of the mortgage-backed
    securities used to secure these debt obligations could limit our
    ability to borrow or result in lenders requiring us to pledge
    additional collateral to secure our borrowings. In that
    situation, we could be required to sell mortgage-backed
    securities under adverse market conditions in order to obtain
    the additional collateral required by the lender. If these sales
    are made at prices lower than the carrying value of the
    mortgage-backed securities, we would experience losses.
|
| |  | A default under a mortgage-related asset that
    constitutes collateral for a loan could also result in an
    involuntary liquidation of the mortgage-related asset, including
    any cross-collateralized mortgage-backed securities. This would
    result in a loss to us of the difference between the value of
    the mortgage-related asset upon liquidation and the amount
    borrowed against the mortgage-related asset.                                                                                                                                                                                                                                                                       
|
| |  | To the extent we are compelled to liquidate
    qualified REIT assets to repay debts, our compliance with the
    REIT rules regarding our assets and our sources of income could
    be negatively affected, which would jeopardize our status as a
    REIT. Losing our REIT status would cause us to lose tax
    advantages applicable to REITs and would decrease our overall
    profitability and distributions to our stockholders.                                                                                                                                                                                                                                                                  
|
| |  | If we experience losses as a result of our
    leverage policy, such losses would reduce the amounts available
    for distribution to our stockholders.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     



| |                                                                                                
| | -----------------------------------------------------------------------------------------------
| | We might not be able to use derivatives to
    mitigate our interest rate and prepayment risks.

Our policies permit us to enter into interest
rate swaps, caps and floors and other derivative transactions to
help us reduce our interest rate and prepayment risks. As of
December 31, 2003, we were engaged in short sales of
Eurodollar futures contracts in order to hedge the impact of
changes in interest rates on our liability costs. In the future,
these transactions might mitigate our interest rate and
prepayment risks, but cannot eliminate these risks. Moreover,
the use of derivative transactions could have a negative impact
on our earnings and our status as a REIT, and, therefore, our
use of such derivatives could be limited.

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| |                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may enter into ineffective derivative
    transactions or other hedging activities that may reduce our net
    interest income or cause us to suffer losses.

Our policies permit us to, but we are not
required to, enter into derivative transactions such as interest
rate swaps, caps and floors and other derivative transactions to
help us seek to reduce our interest rate and prepayment risks.
The effectiveness of any derivative transactions will depend
significantly upon whether we correctly quantify the interest
rate or prepayment risks being hedged, our execution of and
ongoing monitoring of our hedging activities, and the treatment
of such hedging activities for GAAP accounting purposes.

As of December 31, 2003, we were engaged in
short sales of Eurodollar futures contracts in order to hedge
the impact of changes in interest rates on our liability costs.
In the case of these hedges, and any other future efforts to
hedge the effects of interest rate changes on our liability
costs, if we enter into hedging instruments that have higher
interest rates embedded in them as a result of the forward yield
curve, and at the end of the term of these hedging instruments
the spot market interest rates for the liabilities that we
hedged are actually lower, then we will have locked in higher
interest rates for our liabilities than would be available in
the spot market at the time and this could result in a narrowing
of our net interest rate margin or result in losses. In some
situations, we may sell assets or hedging instruments at a loss
in order to maintain adequate liquidity.

In addition, we apply SFAS No. 133,
Accounting for Derivative Instruments and Hedging
Activities, as amended and interpreted, and record
derivatives at fair value. If the derivatives meet the criteria
to be accounted for as hedging transactions, the effects of the
transactions could be materially different as to timing than if
they do not qualify as hedges, and this may cause a narrowing of
our net interest rate margin or result in losses.



| |                                                                         
| | ------------------------------------------------------------------------
| | An increase in interest rates might
    adversely affect our book value.

We use changes in 10-year U.S. Treasury
yields as a reference indicator for changes in interest rates
because it is a common market benchmark. Increases in the
general level of interest rates can cause the fair market value
of our assets to decline, particularly those mortgage-backed
securities whose underlying mortgages have fixed-rate
components. Our fixed-rate mortgage securities and our hybrid
adjustable-rate mortgage-backed securities (during the
fixed-rate component of the mortgages underlying such
securities) will generally be more negatively affected by such
increases than our adjustable-rate mortgage securities. In
accordance with GAAP, we will be required to reduce the carrying
value of our mortgage-backed securities by the amount of any
decrease in the fair value of our mortgage-backed securities
compared to their respective amortized costs. If unrealized
losses in fair value occur, we will have to either reduce
current earnings or reduce stockholders equity without
immediately affecting current earnings, depending on how we
classify such mortgage-backed securities under GAAP. In either
case, our net book value will decrease to the extent of any
realized or unrealized losses in fair value.



| |                                                                                                                                                                                                              
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may invest in leveraged mortgage
    derivative securities that generally experience greater
    volatility in market prices, and thus expose us to greater risk
    with respect to their rate of return.

We may acquire leveraged mortgage derivative
securities that expose us to a high level of interest rate risk.
The characteristics of leveraged mortgage derivative securities
cause those securities to experience greater volatility in their
market prices. Thus, acquisition of leveraged mortgage
derivative securities will expose us to the risk of greater
volatility in our portfolio, which could reduce our net income
and harm our overall results of operations.



| |                                                                                                                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We depend on borrowings to purchase
    mortgage-related assets and reach our desired amount of
    leverage. If we fail to obtain or renew sufficient funding on
    favorable terms or at all, we will be limited in our ability to
    acquire mortgage-related assets, which will harm our results of
    operations.

We depend on short-term borrowings to fund
acquisitions of mortgage-related assets and reach our desired
amount of leverage. Accordingly, our ability to achieve our
investment and leverage objectives

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depends on our ability to borrow money in
sufficient amounts and on favorable terms. In addition, we must
be able to renew or replace our maturing short-term borrowings
on a continuous basis. We depend on a few lenders to provide the
primary credit facilities for our purchases of mortgage-related
assets. In addition, our existing indebtedness may limit our
ability to make additional borrowings. If our lenders do not
allow us to renew our borrowings or we cannot replace maturing
borrowings on favorable terms or at all, we might have to sell
our mortgage-related assets under adverse market conditions,
which would harm our results of operations and may result in
permanent losses.




| |                                                                                                                                                                                                                                                                                                               
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Possible market developments could cause
    our lenders to require us to pledge additional assets as
    collateral. If our assets are insufficient to meet the
    collateral requirements, we might be compelled to liquidate
    particular assets at inopportune times and at disadvantageous
    prices.

Possible market developments, including a sharp
or prolonged rise in interest rates, a change in prepayment
rates or increasing market concern about the value or liquidity
of one or more types of mortgage-backed securities in which our
portfolio is concentrated, might reduce the market value of our
portfolio, which might cause our lenders to require additional
collateral. Any requirement for additional collateral might
compel us to liquidate our assets at inopportune times and at
disadvantageous prices, thereby harming our operating results.
If we sell mortgage-backed securities at prices lower than the
carrying value of the mortgage-backed securities, we would
experience losses.



| |                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our use of repurchase agreements to borrow
    funds may give our lenders greater rights in the event that
    either we or any of our lenders file for
    bankruptcy.

Our borrowings under repurchase agreements may
qualify for special treatment under the bankruptcy code, giving
our lenders the ability to avoid the automatic stay provisions
of the bankruptcy code and to take possession of and liquidate
our collateral under the repurchase agreements without delay if
we file for bankruptcy. Furthermore, the special treatment of
repurchase agreements under the bankruptcy code may make it
difficult for us to recover our pledged assets in the event that
our lender files for bankruptcy. Thus, the use of repurchase
agreements exposes our pledged assets to risk in the event of a
bankruptcy filing by either our lender or us.



| |                                                                                                                                                                                      
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Because the assets that we acquire might
    experience periods of illiquidity, we might be prevented from
    selling our mortgage-related assets at opportune times and
    prices.

We bear the risk of being unable to dispose of
our mortgage-related assets at advantageous times and prices or
in a timely manner because mortgage-related assets generally
experience periods of illiquidity. The lack of liquidity might
result from the absence of a willing buyer or an established
market for these assets, as well as legal or contractual
restrictions on resale. If we are unable to sell our
mortgage-related assets at opportune times, we might suffer a
loss and/or reduce our distributions.



| |                                                                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our board of directors may change our
    operating policies and strategies without prior notice or
    stockholder approval and such changes could harm our business
    and results of operations and the value of our
    stock.

Our board of directors has the authority to
modify or waive our current operating policies and our
strategies (including our election to operate as a REIT) without
prior notice and without stockholder approval. We cannot predict
the effect any changes to our current operating policies and
strategies would have on our business, operating results and
value of our stock. However, the effects might be adverse.



| |                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------
| | Competition might prevent us from acquiring
    mortgage-backed securities at favorable yields, which would harm
    our results of operations.

Our net income depends on our ability to acquire
mortgage-backed securities at favorable spreads over our
borrowing costs. In acquiring mortgage-backed securities, we
compete with other REITs, investment banking firms, savings and
loan associations, banks, insurance companies, mutual funds,
other lenders and

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other entities that purchase mortgage-backed
securities, many of which have greater financial resources than
we do. As a result, we may not be able to acquire sufficient
mortgage-backed securities at favorable spreads over our
borrowing costs, which would harm our results of operations.




| |                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Defaults on the mortgage loans underlying
    our mortgage-backed securities may reduce the value of our
    investment portfolio and may harm our results of
    operations.

We bear the risk of any losses resulting from any
defaults on the mortgage loans underlying the mortgage-backed
securities in our investment portfolio. Many of the
mortgage-backed securities that we obtain will have one or more
forms of credit enhancement provided by third parties, such as
insurance against risk of loss due to default on the underlying
mortgage loans or bankruptcy, fraud and special hazard losses.
To the extent that third parties have been contracted to insure
against these types of losses, the value of such insurance will
depend in part on the creditworthiness and claims-paying ability
of the insurer and the timeliness of reimbursement in the event
of a default on the underlying obligations. Further, the
insurance coverage for various types of losses is limited in
amount, and losses in excess of these limitations would be borne
by us.

Other mortgage-backed securities that we purchase
will be subject to limited guarantees of the payment of limited
amounts of principal and interest on mortgage loans underlying
such mortgage-backed securities, either by federal government
agencies, including Ginnie Mae, by federally-chartered
corporations, including Fannie Mae and Freddie Mac, or by other
corporate guarantors. While Ginnie Maes obligations are
backed by the full faith and credit of the United States, the
obligations of Fannie Mae and Freddie Mac and other corporate
guarantors are solely their own. As a result, a substantial
deterioration in the financial strength of Fannie Mae, Freddie
Mac or other corporate guarantors could increase our exposure to
future delinquencies, defaults or credit losses on our holdings
of Fannie Mae or Freddie Mac-backed mortgage-backed securities
or other corporate-backed mortgage-backed securities, and could
harm our results of operations. In addition, while Freddie Mac
guarantees the eventual payment of principal, it does not
guarantee the timely payment thereof, and our results of
operations may be harmed if borrowers are late or delinquent in
their payments on mortgages underlying Freddie Mac-backed
mortgage-backed securities. Moreover, Fannie Mae, Freddie Mac,
Ginnie Mae and other corporate guarantees relate only to
payments of limited amounts of principal and interest on the
mortgages underlying such agency-backed or corporate-backed
securities, and do not guarantee the market value of such
mortgage-backed securities or the yields on such mortgage-backed
securities. As a result, we remain subject to interest rate
risks, prepayment risks, extension risks and other risks
associated with our investment in such mortgage-backed
securities and may experience losses in our investment portfolio.



| |                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------
| | We remain subject to losses despite our
    strategy of investing in highly-rated mortgage-backed
    securities.

Our investment guidelines provide that at least
90% of our assets must be invested in mortgage-backed securities
that are either agency-backed or are rated at least investment
grade by at least one rating agency. While highly-rated
mortgage-backed securities are generally subject to a lower risk
of default than lower credit quality mortgage-backed securities
and may benefit from third-party credit enhancements such as
insurance or corporate guarantees, there is no assurance that
such mortgage-backed securities will not be subject to credit
losses. Furthermore, ratings are subject to change over time as
a result of a number of factors, including greater than expected
delinquencies, defaults or credit losses, or a deterioration in
the financial strength of corporate guarantors, any of which may
reduce the market value of such securities. Furthermore, ratings
do not take into account the reasonableness of the issue price,
interest risks, prepayment risks, extension risks or other risks
associated with such mortgage-backed securities. As a result,
while we attempt to mitigate our exposure to credit risk on a
relative basis by focusing on highly-rated mortgage-backed
securities, we cannot eliminate such credit risks and remain
subject to other risks to our investment portfolio and may
suffer losses, which may harm the market price of our common
stock.

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| |                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------
| | Decreases in the value of the property
    underlying our mortgage-backed securities might decrease the
    value of our assets.

The mortgage-backed securities in which we invest
are secured by underlying real property interests. To the extent
that the value of the property underlying our mortgage-backed
securities decreases, our security might be impaired, which
might decrease the value of our assets.



| |                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------
| | Insurance will not cover all potential
    losses on the underlying real property and the absence thereof
    may harm the value of our assets.

Under our asset acquisition policy, we are
permitted to invest up to a maximum of 10% of our total assets
in assets other than mortgage-backed securities guaranteed by
federal agencies or federally chartered entities such as Fannie
Mae, Freddie Mac or Ginnie Mae, or rated as at least investment
grade by a nationally recognized statistical rating agency.
Mortgage loans fall outside of this category of investments
under our investment guidelines and are subject to the 10%
limitation. If we elect in the future to purchase mortgage
loans, we may require that each of the mortgage loans that we
purchase include comprehensive insurance covering the underlying
real property, including liability, fire and extended coverage.
There are certain types of losses, however, generally of a
catastrophic nature, such as earthquakes, floods and hurricanes,
that may be uninsurable or not economically insurable.
Inflation, changes in building codes and ordinances,
environmental considerations, and other factors also might make
it infeasible to use insurance proceeds to replace a property if
it is damaged or destroyed. Under such circumstances, the
insurance proceeds, if any, might not be adequate to restore the
economic value of the underlying real property, which might
impair our security and decrease the value of our assets.



| |                                                                  
| | -----------------------------------------------------------------
| | Distressed mortgage loans have higher risk
    of future default.

If we elect in the future to purchase mortgage
loans, we may purchase distressed mortgage loans as well as
mortgage loans that have had a history of delinquencies. These
distressed mortgage loans may be in default or may have a
greater than normal risk of future defaults and delinquencies,
as compared to a pool of newly-originated, high quality loans of
comparable type, size and geographic concentration. Returns on
an investment of this type depend on accurate pricing of such
investment, the borrowers ability to make required
payments or, in the event of default, the ability of the
loans servicer to foreclose and liquidate the mortgage
loan. We cannot assure you that the servicer will be able to
liquidate a defaulted mortgage loan in a cost-effective manner,
at an advantageous price or in a timely manner.



| |                                                                   
| | ------------------------------------------------------------------
| | Subordinated loans on real estate are
    subject to higher risks.

If we elect in the future to purchase mortgage
loans, we may acquire loans secured by commercial properties,
including loans that are subordinate to first liens on the
underlying commercial real estate. Subordinated mortgage loans
are subject to greater risks of loss than first lien mortgage
loans. An overall decline in the real estate market could reduce
the value of the real property securing such loans such that the
aggregate outstanding balance of the second-lien loan and the
balance of the more senior loan on the real property exceed the
value of the real property.



| |                                                                                                                                        
| | ---------------------------------------------------------------------------------------------------------------------------------------
| | We depend on our key personnel and the loss
    of any of our key personnel could severely and detrimentally
    affect our operations.

We depend on the diligence, experience and skill
of our officers and the people working on behalf of our manager
for the selection, acquisition, structuring and monitoring of
our mortgage-related assets and associated borrowings. Our key
officers include Gail Seneca, Albert Gutierrez, Christopher
Zyda, Andrew Chow and Troy Grande. We have not entered into
employment agreements with our senior officers other than
Mr. Zyda, who is our Senior Vice President and Chief
Financial Officer. With the exception of Mr. Zyda, we do
not currently employ personnel dedicated solely to our business,
and our officers are free to engage in competitive activities in
our industry. The loss of any key person could harm our
business, financial condition, cash flow and results of
operations.

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Risks Related to Our Manager



| |                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Manager has not managed a REIT and we
    cannot assure you that the Managers past experience will
    be sufficient to successfully manage our business as a
    REIT.

Seneca Capital Management LLC has not previously
managed a REIT, and does not have any experience in complying
with the income, asset and other limitations imposed by the REIT
provisions of the Internal Revenue Code. Those provisions are
complex and the failure to comply with those provisions in a
timely manner could prevent us from qualifying as a REIT or
could force us to pay unexpected taxes and penalties. In such
event, our net income would be reduced and we could incur a loss.



| |                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our manager has significant influence over
    our affairs, and might cause us to engage in transactions that
    are not in our or our stockholders best
    interests.

In addition to managing us and having at least
two of its designees as members of our board, the Manager
provides advice on our operating policies and strategies. The
Manager may also cause us to engage in future transactions with
the Manager and its affiliates, subject to the approval of, or
guidelines approved by, the independent members of our board of
directors. Our directors, however, rely primarily on information
supplied by our manager in reaching their determinations.
Accordingly, our manager has significant influence over our
affairs, and may cause us to engage in transactions which are
not in our best interest.



| |                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our manager and its affiliates might
    allocate mortgage-related opportunities to other entities, and
    thus might divert attractive investment opportunities away from
    us.

Our operations and assets are managed by
specified individuals at the Manager. The Manager and its
affiliates, including some of our officers, manage portfolios
for parties unrelated to us. These multiple responsibilities
might create conflicts of interest for the Manager and these
individuals if they are presented with opportunities that might
benefit us and their other clients. The Manager and these
individuals must allocate investments among our portfolio and
their other clients by determining the entity or account for
which the investment is most suitable. In making this
determination, the Manager and these individuals consider the
investment strategy and guidelines of each entity or account
with respect to acquisition of assets, leverage, liquidity and
other factors that the Manager and these individuals determine
appropriate. However, the Manager and those working on its
behalf have no obligation to make any specific investment
opportunities available to us and the above-mentioned conflicts
of interest might result in decisions or allocations of
investments that are not in our or our stockholders best
interests.



| |                                                                                                                                                                                                                                                     
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We will pay the Manager incentive
    compensation based on our portfolios performance. This
    arrangement may lead the Manager to recommend riskier or more
    speculative investments in an effort to maximize its incentive
    compensation.

In addition to its base management fee, the
Manager earns incentive compensation for each fiscal quarter
equal to a specified percentage of the amount by which our
return on equity, before deducting incentive compensation,
exceeds a return based on the 10 year U.S. Treasury
rate plus 2%. The percentage for this calculation is the
weighted average of the following percentages based on our
average net invested assets for the period:



| |   |                                                                           
| | - | --------------------------------------------------------------------------
| |  | 20% for the first $400 million of our
    average net invested assets; and
|
| |  | 10% of our average net invested assets in excess
    of $400 million.     

Pursuant to the formula for calculating the
Managers incentive compensation, the Manager shares in our
profits but not in our losses. Consequently, as the Manager
evaluates different mortgage-backed securities and other
investments for our account, there is a risk that the Manager
will cause us to assume more risk than is prudent in an attempt
to increase its incentive compensation. Other key criteria
related to determining appropriate investments and investment
strategies, including the preservation of capital,

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might be under-weighted if the Manager focuses
exclusively or disproportionately on maximizing its income.




| |                                                                                           
| | ------------------------------------------------------------------------------------------
| | We may be obligated to pay the Manager
    incentive compensation even if we incur a loss.

Pursuant to the Management Agreement, the Manager
is entitled to receive incentive compensation for each fiscal
quarter in an amount equal to a tiered percentage of the excess
of our taxable income for that quarter (before deducting
incentive compensation, net operating losses and certain other
items) above a threshold return for that quarter. In addition,
the Management Agreement further provides that our taxable
income for incentive compensation purposes excludes net capital
losses that we may incur in the fiscal quarter, even if such
capital losses result in a net loss on our statement of
operations for that quarter. Thus, we may be required to pay the
Manager incentive compensation for a fiscal quarter even if
there is a decline in the value of our portfolio or we incur a
net loss for that quarter.



| |                                                                                                                                                                                                                                                                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | During periods of declining market prices
    for shares of our common stock, we may be required to issue
    greater numbers of shares to the Manager for the same amount of
    incentive compensation arising under the Management Agreement,
    which will have a dilutive effect on our stockholders that may
    harm the market price of our common stock.

Pursuant to the terms of the Management
Agreement, the incentive compensation payable to the Manager for
each fiscal quarter is paid one-half in cash and one-half in
restricted shares of our common stock. The number of shares to
be issued to the Manager is based on (a) one-half of the
total incentive compensation for the period, divided by
(b) the average of the closing prices of the common stock
over the 30 day period ending three days prior to the grant
date, less a fair market value discount determined by our board
of directors. During periods of declining market prices for
shares of our common stock, we may be required to issue more
shares to the Manager for the same amount of incentive
compensation. Although these shares will initially be subject to
restrictions on transfer which lapse ratably over a three-year
period, the issuance of these shares will have a dilutive effect
on our stockholders which may harm the market price of our
common stock.



| |                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Because the Manager might receive a
    significant fee if we terminate the Management Agreement,
    economic considerations might preclude us from terminating the
    Management Agreement in the event that the Manager fails to meet
    our expectations.

If we terminate the Management Agreement without
cause or because we decide to manage our company internally or
if the Manager terminates the management in the event of a
change of control, then we will have to pay a significant fee to
the Manager. The amount of the fee depends on whether:



| |   |                                                                                                                                                                                                                                                                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | we terminate the Management Agreement without
    cause in connection with a decision to manage our portfolio
    internally, in which case we will be obligated to pay to the
    Manager a fee equal to the highest amount of management fees
    incurred in a particular year during the then three most recent
    years; or                               
|
| |  | our decision to terminate the Management
    Agreement without cause is for a reason other than our decision
    to manage our portfolio internally, in which case we will be
    obligated to pay the Manager an amount equal to two times the
    highest amount of management fees incurred in a particular year
    during the then three most recent years.

In each of the above cases, the Manager will also
receive accelerated vesting of the equity component of its
incentive compensation. The actual amount of such fee cannot be
known at this time because it is based in part on the
performance of our portfolio of mortgage-backed securities.
Paying this fee would reduce significantly the cash available
for distribution to our stockholders and might cause us to
suffer a net operating loss. Consequently, terminating the
Management Agreement might not be advisable even if we determine
that it would be more efficient to operate with an internal
management structure or if we are otherwise dissatisfied with
the Managers performance.

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| |                                                                                                                                                                                                                                                                                                                                          
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Investors may not be able to estimate with
    certainty the aggregate fees and expense reimbursements that
    will be paid to the Manager under the Management Agreement and
    the cost-sharing agreement due to the time and manner in which
    the Managers incentive compensation and expense
    reimbursements are determined.

The Manager may be entitled to substantial fees
pursuant to the Management Agreement. The Managers base
management fee is calculated as a percentage of our average net
worth. The Managers incentive compensation is calculated
as a tiered percentage of our taxable income (before deducting
certain items) in excess of a threshold amount of taxable income
and is indeterminable in advance of a particular period. Since
future payments of base management fees, incentive compensation
and expense reimbursements are determined at future dates based
upon our then-applicable average net worth, results of
operations and actual expenses incurred by the Manager, such
fees and expense reimbursements cannot be estimated with
mathematical certainty. Any base management fees, incentive
compensation or expense reimbursements payable to the Manager
may be materially greater or less than the historical amounts
and we can provide no assurance at this time as to the amount of
any such base management fee, incentive compensation or expense
reimbursements that may be payable to the Manager in the future.



| |                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------
| | The Manager may render services to other
    mortgage investors, which could reduce the amount of time and
    effort that the Manager devotes to us.

Our Management Agreement with the Manager does
not restrict the right of the Manager, any persons working on
its behalf or any of its affiliates, to carry on their
respective businesses, including the rendering of advice to
others regarding the purchase of mortgage-backed securities that
would meet our investment criteria. In addition, the Management
Agreement does not specify a minimum time period that the
Manager and its personnel must devote to managing our
investments. The ability of the Manager to engage in these other
business activities, and specifically to manage mortgage-related
assets for third parties, could reduce the time and effort it
spends managing our portfolio to the detriment of our investment
returns.



| |                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------
| | The Managers liability is limited
    under the Management Agreement, and we have agreed to indemnify
    the Manager against certain liabilities.

The Manager has not assumed any responsibility to
us other than to render the services described in the Management
Agreement, and will not be responsible for any action of our
board of directors in declining to follow the Managers
advice or recommendations. the Manager and its directors,
officers and employees will not be liable to us for acts
performed by its officers, directors, or employees in accordance
with and pursuant to the Management Agreement, except for acts
constituting gross negligence, recklessness, willful misconduct
or active fraud in connection with their duties under the
Management Agreement. We have agreed to indemnify the Manager
and its directors, officers and employees with respect to all
expenses, losses, damages, liabilities, demands, charges and
claims arising from acts of the Manager not constituting gross
negligence, recklessness, willful misconduct or active fraud.

Legal and Tax Risks



| |                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------
| | If we are disqualified as a REIT, we will
    be subject to tax as a regular corporation and face substantial
    tax liability.

Qualification as a REIT involves the application
of highly technical and complex U.S. federal income tax
code provisions for which only a limited number of judicial or
administrative interpretations exist. Accordingly, it is not
certain we will be able to become and remain qualified as a REIT
for U.S. federal income tax purposes. Even a technical or
inadvertent mistake could jeopardize our REIT status.
Furthermore, Congress or the Internal Revenue Service, or IRS,
might change tax laws or regulations and the courts might issue
new rulings, in each case potentially having retroactive effect,
that could make it

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more difficult or impossible for us to qualify as
a REIT. If we fail to qualify as a REIT in any tax year, then:




| |   |                                                                                                                                                                                                                                                                                                                                                                                                        
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | we would be taxed as a regular domestic
    corporation, which, among other things, means that we would be
    unable to deduct distributions to stockholders in computing
    taxable income and we would be subject to U.S. federal
    income tax on our taxable income at regular corporate rates;                                                                                                 
|
| |  | any resulting tax liability could be substantial,
    would reduce the amount of cash available for distribution to
    stockholders, and could force us to liquidate assets at
    inopportune times, causing lower income or higher losses than
    would result if these assets were not liquidated; and                                                                                            
|
| |  | unless we were entitled to relief under
    applicable statutory provisions, we would be disqualified from
    treatment as a REIT for the subsequent four taxable years
    following the year during which we lost our qualification and,
    thus, our cash available for distribution to our stockholders
    would be reduced for each of the years during which we did not
    qualify as a REIT.

Even if we remain qualified as a REIT, we might
face other tax liabilities that reduce our cash flow. Further,
we might be subject to federal, state and local taxes on our
income and property. Any of these taxes would decrease cash
available for distribution to our stockholders.



| |                                                                                                      
| | -----------------------------------------------------------------------------------------------------
| | Complying with REIT requirements might
    cause us to forego otherwise attractive
    opportunities.

In order to qualify as a REIT for
U.S. federal income tax purposes, we must satisfy tests
concerning, among other things, our sources of income, the
nature and diversification of our mortgage-backed securities,
the amounts we distribute to our stockholders and the ownership
of our stock. We may also be required to make distributions to
our stockholders at disadvantageous times or when we do not have
funds readily available for distribution. Thus, compliance with
REIT requirements may cause us to forego opportunities we would
otherwise pursue.

In addition, the REIT provisions of the Internal
Revenue Code impose a 100% tax on income from prohibited
transactions. Prohibited transactions generally include
sales of assets that constitute inventory or other property held
for sale in the ordinary course of a business, other than
foreclosure property. This 100% tax could impact our desire to
sell mortgage-backed securities at otherwise opportune times if
we believe such sales could be considered a prohibited
transaction.



| |                                                                                 
| | --------------------------------------------------------------------------------
| | Complying with REIT requirements may limit
    our ability to hedge effectively.

The existing REIT provisions of the Internal
Revenue Code substantially limit our ability to hedge
mortgage-backed securities and related borrowings. Under these
provisions, our annual income from qualified hedges, together
with any other income not generated from qualified REIT real
estate assets, is limited to less than 25% of our gross income.
In addition, we must limit our aggregate income from hedging and
services from all sources, other than from qualified REIT real
estate assets or qualified hedges, to less than 5% of our annual
gross income. As a result, we might in the future have to limit
our use of advantageous hedging techniques. This could leave us
exposed to greater risks associated with changes in interest
rates than we would otherwise want to bear. If we were to
violate the 25% or 5% limitations, we might have to pay a
penalty tax equal to the amount of our income in excess of those
limitations, multiplied by a fraction intended to reflect our
profitability. If we fail to satisfy the 25% or 5% limitations,
unless our failure was due to reasonable cause and not due to
willful neglect, we could lose our REIT status for federal
income tax purposes.



| |                                                                                                 
| | ------------------------------------------------------------------------------------------------
| | Complying with REIT requirements may force
    us to liquidate otherwise attractive investments.

In order to qualify as a REIT, we must ensure
that at the end of each calendar quarter at least 75% of the
value of our assets consists of cash, cash items, government
securities and qualified REIT real estate assets. The remainder
of our investment in securities generally cannot include more
than 10% of the outstanding voting securities of any one issuer
or more than 10% of the total value of the outstanding
securities of any one issuer. In addition, generally, no more
than 5% of the value of our assets can consist

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of the securities of any one issuer. If we fail
to comply with these requirements, we must dispose of a portion
of our assets within 30 days after the end of the calendar
quarter in order to avoid losing our REIT status and suffering
adverse tax consequences.




| |                                                                                                           
| | ----------------------------------------------------------------------------------------------------------
| | Complying with REIT requirements may force
    us to borrow to make distributions to our
    stockholders.

As a REIT, we must distribute 90% of our annual
taxable income (subject to certain adjustments) to our
stockholders. From time to time, we might generate taxable
income greater than our net income for financial reporting
purposes from, among other things, amortization of capitalized
purchase premiums, or our taxable income might be greater than
our cash flow available for distribution to our stockholders. If
we do not have other funds available in these situations, we
might be unable to distribute 90% of our taxable income as
required by the REIT rules. In that case, we would need to
borrow funds, sell a portion of our mortgage-backed securities
potentially at disadvantageous prices or find another
alternative source of funds. These alternatives could increase
our costs or reduce our equity and reduce amounts available to
invest in mortgage-backed securities.



| |                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------
| | Failure to maintain an exemption from the
    Investment Company Act, would harm our results of
    operations.

We intend to conduct our business so as not to
become regulated as an investment company under the Investment
Company Act of 1940, as amended. If we fail to qualify for this
exemption, our ability to use leverage would be substantially
reduced and we would be unable to conduct our business as
described in this annual report on Form 10-K.

The Investment Company Act exempts entities that
are primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on, and interests in, real
estate. Under the current interpretation of the SEC staff, in
order to qualify for this exemption, we must maintain at least
55% of our assets directly in these qualifying real estate
interests. Mortgage-backed securities that do not represent all
of the certificates issued with respect to an underlying pool of
mortgages may be treated as separate from the underlying
mortgage loans and, thus, may not qualify for purposes of the
55% requirement. Therefore, our ownership of these
mortgage-backed securities is limited by the provisions of the
Investment Company Act.

In satisfying the 55% requirement under the
Investment Company Act, we treat as qualifying interests
mortgage-backed securities issued with respect to an underlying
pool as to which we hold all issued certificates. If the SEC or
its staff adopts a contrary interpretation of such treatment, we
could be required to sell a substantial amount of our
mortgage-backed securities under potentially adverse market
conditions. Further, in our attempts to ensure that we at all
times qualify for the exemption under the Investment Company
Act, we might be precluded from acquiring mortgage-backed
securities if their yield is higher than the yield on
mortgage-backed securities that could be purchased in a manner
consistent with the exemption. These factors may lower or
eliminate our net income.



| |                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Misplaced reliance on legal opinions or
    statements by issuers of mortgage-backed securities could result
    in a failure to comply with REIT income or assets
    tests.

When purchasing mortgage-backed securities, we
may rely on opinions of counsel for the issuer or sponsor of
such securities, or statements made in related offering
documents, for purposes of determining whether and to what
extent those securities constitute REIT real estate assets for
purposes of the REIT asset tests and produce income that
qualifies under the REIT gross income tests. The inaccuracy of
any such opinions or statements may adversely affect our REIT
qualification and result in significant corporate-level tax.



| |                                                                    
| | -------------------------------------------------------------------
| | One-action rules may harm the value of the
    underlying property.

Several states have laws that prohibit more than
one action to enforce a mortgage obligation, and some courts
have construed the term action broadly. In such
jurisdictions, if the judicial action is not

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conducted according to law, there may be no other
recourse in enforcing a mortgage obligation, thereby decreasing
the value of the underlying property.




| |                                                                 
| | ----------------------------------------------------------------
| | We may be harmed by changes in various laws
    and regulations.

Changes in the laws or regulations governing the
Manager or its affiliates may impair the Managers or its
affiliates ability to perform services in accordance with
the Management Agreement. Our business may be harmed by changes
to the laws and regulations affecting our manager or us,
including changes to securities laws and changes to the Internal
Revenue Code applicable to the taxation of REITs. New
legislation may be enacted into law or new interpretations,
rulings or regulations could be adopted, any of which could harm
us, our manager and our stockholders, potentially with
retroactive effect.

Legislation was recently enacted that reduces the
maximum tax rate of non-corporate taxpayers for capital gains
(for taxable years ending on or after May 6, 2003 and
before January 1, 2009) and for dividends (for taxable
years beginning after December 31, 2002 and before
January 1, 2009) to 15%. Generally, dividends paid by REITs
are not eligible for the new 15% federal income tax rate, with
certain exceptions discussed at United States Federal
Income Tax Considerations  Taxation of Taxable United
States Stockholders  Distributions Generally.
Although this legislation does not adversely affect the taxation
of REITs or dividends paid by REITs, the more favorable
treatment of regular corporate dividends could cause investors
who are individuals to consider stocks of other corporations
that pay dividends as more attractive relative to stocks of
REITs. It is not possible to predict whether this change in
perceived relative value will occur, or what the effect will be
on the market price of our common stock.

In addition, legislation was recently introduced
in the United States House of Representatives and the United
States Senate that would amend certain rules relating to REITs.
Among other changes, the proposed legislation would provide the
Internal Revenue Service with the ability to impose monetary
penalties, rather than a loss of REIT status, for reasonable
cause violations of certain tests relating to REIT
qualification, and would change the formula for calculating the
tax imposed for certain violations of the income tests discussed
at United States Federal Income Tax
Considerations  Requirements for Qualification as a
REIT  Income Tests. In general, the changes
would apply to taxable years beginning after the date the
legislation is enacted. As of the date hereof, it is not
possible to predict with any certainty whether the proposed
legislation will be enacted in its current form.



| |                                                                                                        
| | -------------------------------------------------------------------------------------------------------
| | We may incur excess inclusion income that
    would increase the tax liability of our
    stockholders.

In general, dividend income that a tax-exempt
entity receives from us should not constitute unrelated business
taxable income as defined in Section 512 of the Internal
Revenue Code. If we realize excess inclusion income and allocate
it to stockholders, this income cannot be offset by net
operating losses. If the stockholder is a tax-exempt entity,
then this income would be fully taxable as unrelated business
taxable income under Section 512 of the Internal Revenue
Code. If the stockholder is foreign, it would be subject to
U.S. federal income tax withholding on this income without
reduction pursuant to any otherwise applicable income-tax treaty.

Excess inclusion income could result if we held a
residual interest in a real estate mortgage investment conduit,
or REMIC. Excess inclusion income also would be generated if we
were to issue debt obligations with two or more maturities and
the terms of the payments on these obligations bore a
relationship to the payments that we received on our
mortgage-backed securities securing those debt obligations. We
generally structure our borrowing arrangements in a manner
designed to avoid generating significant amounts of excess
inclusion income. We do, however, enter into various repurchase
agreements that have differing maturity dates and afford the
lender the right to sell any pledged mortgage securities if we
default on our obligations. The IRS may determine that these
borrowings give rise to excess inclusion income that should be
allocated among stockholders. Furthermore, some types of
tax-exempt entities, including voluntary employee benefit
associations and entities that have borrowed funds to acquire
their shares of our common stock, may be required to treat a
portion of or all of the dividends they may receive

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from us as unrelated business taxable income.
Finally, we may invest in equity securities of other REITs and
it is possible that we might receive excess inclusion income
from those investments.







|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    About Market Risk

Our primary component of market risk is interest
rate risk, as described below. While we do not seek to avoid
risk completely, we do seek to assume risk that can be
quantified from historical experience, to actively manage that
risk, to earn sufficient compensation to justify taking those
risks and to maintain capital levels consistent with the risks
we undertake.

Interest Rate Risk

We are subject to interest rate risk in
connection with our investments in fixed-rate, adjustable-rate
and hybrid adjustable-rate mortgage-backed securities and our
related debt obligations, which are generally repurchase
agreements of limited duration that are periodically refinanced
at current market rates, and our derivative contracts.



| |                              
| | -----------------------------
| | Effect on Net Interest Income

We fund our investments in some long-term,
fixed-rate and hybrid adjustable-rate mortgage-backed securities
with short-term borrowings under repurchase agreements. During
periods of rising interest rates, the borrowing costs associated
with those fixed-rate and hybrid-adjustable rate mortgage-backed
securities tend to increase while the income earned on such
fixed-rate and hybrid adjustable-rate mortgage-backed securities
(during the fixed-rate component of such securities) may remain
substantially unchanged. This results in a narrowing of the net
interest spread between the related assets and borrowings and
may even result in losses.

As a means to mitigate the negative impact of a
rising interest rate environment, we have entered into
derivative transactions, specifically Eurodollar futures
contracts. Hedging techniques are based, in part, on assumed
levels of prepayments of our fixed-rate and hybrid
adjustable-rate mortgage-backed securities. If prepayments are
slower or faster than assumed, the life of the mortgage-backed
securities will be longer or shorter which would reduce the
effectiveness of any hedging strategies we may utilize and may
result in losses on such transactions. Hedging strategies
involving the use of derivative securities are highly complex
and may produce volatile returns. Our hedging activity will also
be limited by the asset and sources-of-income requirements
applicable to us as a REIT.



| |               
| | --------------
| | Extension Risk

We invest in fixed-rate and hybrid
adjustable-rate mortgage-backed securities. Hybrid
adjustable-rate mortgage-backed securities have interest rates
that are fixed for the first few years of the loan 
typically three, five, seven or 10 years  and
thereafter their interest rates reset periodically on the same
basis as adjustable-rate mortgage-backed securities. As of
December 31, 2003, 88.9% of our investment portfolio was
comprised of hybrid adjustable-rate mortgage-backed securities.
We compute the projected weighted-average life of our fixed-rate
and hybrid adjustable-rate mortgage-backed securities based on
the markets assumptions regarding the rate at which the
borrowers will prepay the underlying mortgages. In general, when
a fixed-rate or hybrid adjustable-rate mortgage-backed security
is acquired with borrowings, we may, but are not required to,
enter into an interest rate swap agreement or other hedging
instrument that effectively fixes our borrowing costs for a
period close to the anticipated average life of the fixed-rate
portion of the related mortgage-backed security. This strategy
is designed to protect us from rising interest rates because the
borrowing costs are fixed for the duration of the fixed-rate
portion of the related mortgage-backed security. However, if
prepayment rates decrease in a rising interest rate environment,
the life of the fixed-rate portion of the related
mortgage-backed security could extend beyond the term of the
swap agreement or other hedging instrument. This situation could
negatively impact us as borrowing costs would no longer be fixed
after the end of the hedging instrument while the income earned
on the fixed-rate or hybrid adjustable-rate mortgage-backed
security would remain fixed. This situation may also cause

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the market value of our fixed-rate and hybrid
adjustable-rate mortgage-backed securities to decline with
little or no offsetting gain from the related hedging
transactions. In extreme situations, we may be forced to sell
assets and incur losses to maintain adequate liquidity.




| |                                                                                               
| | ----------------------------------------------------------------------------------------------
| | Adjustable-Rate and Hybrid Adjustable-Rate
    Mortgage-Backed Security Interest Rate Cap Risk

We also invest in adjustable-rate and hybrid
adjustable-rate mortgage-backed securities which are based on
mortgages that are typically subject to periodic and lifetime
interest rate caps and floors, which limit the amount by which
an adjustable-rate or hybrid adjustable-rate mortgage-backed
securitys interest yield may change during any given
period. However, our borrowing costs pursuant to our repurchase
agreements will not be subject to similar restrictions.
Therefore, in a period of increasing interest rates, interest
rate costs on our borrowings could increase without limitation
by caps, while the interest-rate yields on our adjustable-rate
and hybrid adjustable-rate mortgage-backed securities would
effectively be limited by caps. This problem will be magnified
to the extent we acquire adjustable-rate and hybrid
adjustable-rate mortgage-backed securities that are not based on
mortgages which are fully-indexed. In addition, the underlying
mortgages may be subject to periodic payment caps that result in
some portion of the interest being deferred and added to the
principal outstanding. This could result in our receipt of less
cash income on our adjustable-rate and hybrid adjustable-rate
mortgage-backed securities than we need in order to pay the
interest cost on our related borrowings. These factors could
lower our net interest income or cause a net loss during periods
of rising interest rates, which would negatively impact our
financial condition, cash flows and results of operations.



| |                            
| | ---------------------------
| | Interest Rate Mismatch Risk

We intend to fund a substantial portion of our
acquisitions of adjustable-rate and hybrid adjustable-rate
mortgage-backed securities with borrowings that have interest
rates based on indices and repricing terms similar to, but of
somewhat shorter maturities than, the interest rate indices and
repricing terms of the mortgage-backed securities. Thus, we
anticipate that in most cases the interest rate indices and
repricing terms of our mortgage assets and our funding sources
will not be identical, thereby creating an interest rate
mismatch between assets and liabilities. Therefore, our cost of
funds would likely rise or fall more quickly than would our
earnings rate on assets. During periods of changing interest
rates, such interest rate mismatches could negatively impact our
financial condition, cash flows and results of operations. To
mitigate interest rate mismatches, we may utilize hedging
strategies discussed above and in Note 12 to the financial
statements.

Our analysis of risks is based on
managements experience, estimates, models and assumptions.
These analyses rely on models which utilize estimates of fair
value and interest rate sensitivity. Actual economic conditions
or implementation of investment decisions by our management may
produce results that differ significantly from the estimates and
assumptions used in our models and the projected results shown
in this report.



| |                
| | ---------------
| | Prepayment Risk

Prepayments are the full or partial repayment of
principal prior to the original term to maturity of a mortgage
loan and typically occur due to refinancing of mortgage loans.
Prepayment rates for existing mortgage-backed securities
generally increase when prevailing interest rates fall below the
market rate existing when the underlying mortgages were
originated. In addition, prepayment rates on adjustable-rate and
hybrid adjustable-rate mortgage-backed securities generally
increase when the difference between long-term and short-term
interest rates declines or becomes negative. Prepayments of
mortgage-backed securities could harm our results of operations
in several ways. Some adjustable-rate mortgages underlying our
adjustable-rate mortgage-backed securities may bear initial
teaser interest rates that are lower than their
fully-indexed rates, which refers to the applicable
index rates plus a margin. In the event that such an
adjustable-rate mortgage is prepaid prior to or soon after the
time of adjustment to a fully-indexed rate, the holder of the
related mortgage-backed security would have held such security
while it was less profitable and lost the opportunity to receive
interest at the fully-indexed rate over the expected life of the

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adjustable-rate mortgage-backed security.
Although we currently do not own any adjustable-rate
mortgage-backed securities with teaser rates, we may
obtain some in the future which would expose us to this
prepayment risk. Additionally, we currently own mortgage-backed
securities that were purchased at a premium. The prepayment of
such mortgage-backed securities at a rate faster than
anticipated would result in a write-off of any remaining
capitalized premium amount and a consequent reduction of our net
interest income by such amount. Finally, in the event that we
are unable to acquire new mortgage-backed securities to replace
the prepaid mortgage-backed securities, our financial condition,
cash flow and results of operations could be negatively impacted.




| |                     
| | --------------------
| | Effect on Fair Value

Another component of interest rate risk is the
effect changes in interest rates will have on the market value
of our assets. We face the risk that the market value of our
assets will increase or decrease at different rates than that of
our liabilities, including our hedging instruments.

We primarily assess our interest rate risk by
estimating the duration of our assets and the duration of our
liabilities. Duration essentially measures the market price
volatility of financial instruments as interest rates change. We
generally calculate duration using various financial models and
empirical data. Different models and methodologies can produce
different duration numbers for the same securities.

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The following sensitivity analysis table shows
the estimated impact on the fair value of our interest
rate-sensitive investments and repurchase agreement liabilities,
at December 31, 2003, assuming rates instantaneously fall
100 basis points, rise 100 basis points and rise
200 basis points:

|                                                      |  |                       |         |           |  |                |         |                |  |   |         |    |  |   |         |   
|----------------------------------------------------- |  | --------------------- | ------- | --------- |  | -------------- | ------- | -------------- |  | - | ------- | -- |  | - | ------- | --
|                                                      |  | Interest Rates        |         |           |  | Interest Rates |         | Interest Rates
|                                                      |  | Fall 100              |         |           |  | Rise 100       |         | Rise 200      
|                                                      |  | Basis Points          |         | Unchanged |  | Basis Points   |         | Basis Points  
|                                                      |  |                       |         |           |  |                |         |               
|                                                      |  |                      
|                                                      |  | (Dollars in millions)
|Adjustable-Rate Mortgage-Backed
    Securities        |  |                       |         |           |  |                |         |                |  |   |         |    |  |   |         |   
|Fair value                                            |  | $                     | 187.8   |           |  | $              | 185.3   |                |  | $ | 184.2   |    |  | $ | 181.4   |   
|Change in fair value                                  |  | $                     | 2.5     |           |  |                |        |                |  | $ | (1.1    | )  |  | $ | (3.9    | ) 
|Change as a percent of fair value                     |  |                       | 1.3     | %         |  |                |        |                |  |   | (0.6    | )% |  |   | (2.1    | )%
|Hybrid Adjustable-Rate Mortgage-Backed
    Securities |  |                       |         |           |  |                |         |                |  |   |         |    |  |   |         |   
|Fair value                                            |  | $                     | 1,954.4 |           |  | $              | 1,921.9 |                |  | $ | 1,890.8 |    |  | $ | 1,851.2 |   
|Change in fair value                                  |  | $                     | 32.4    |           |  |                |        |                |  | $ | (31.2   | )  |  | $ | (70.8   | ) 
|Change as a percent of fair value                     |  |                       | 1.7     | %         |  |                |        |                |  |   | (1.7    | )% |  |   | (3.8    | )%
|Balloon Mortgage-Backed Securities                    |  |                       |         |           |  |                |         |                |  |   |         |    |  |   |         |   
|Fair value                                            |  | $                     | 56.1    |           |  | $              | 54.7    |                |  | $ | 52.8    |    |  | $ | 53.0    |   
|Change in fair value                                  |  | $                     | 1.4     |           |  |                |        |                |  | $ | (1.9    | )  |  | $ | (1.7    | ) 
|Change as a percent of fair value                     |  |                       | 2.5     | %         |  |                |        |                |  |   | (3.6    | )% |  |   | (3.2    | )%
|Total Mortgage-Backed Securities                      |  |                       |         |           |  |                |         |                |  |   |         |    |  |   |         |   
|Fair value                                            |  | $                     | 2,198.3 |           |  | $              | 2,161.9 |                |  | $ | 2,127.8 |    |  | $ | 2,085.6 |   
|Change in fair value                                  |  | $                     | 36.3    |           |  |                |        |                |  | $ | (34.2   | )  |  | $ | (76.4   | ) 
|Change as a percent of fair value                     |  |                       | 1.7     | %         |  |                |        |                |  |   | (1.6    | )% |  |   | (3.7    | )%
|Repurchase Agreements(1)                              |  |                       |         |           |  |                |         |                |  |   |         |    |  |   |         |   
|Fair value                                            |  | $                     | 1,729.0 |           |  | $              | 1,729.0 |                |  | $ | 1,729.0 |    |  | $ | 1,729.0 |   
|Change in fair value                                  |  |                       |        |           |  |                |        |                |  |   |        |    |  |   |        |   
|Change as a percent of fair value                     |  |                       |        |           |  |                |        |                |  |   |        |    |  |   |        |   
|Hedge Instruments                                     |  |                       |         |           |  |                |         |                |  |   |         |    |  |   |         |   
|Fair value                                            |  | $                     | (5.4    | )         |  | $              | (0.2    | )              |  | $ | 5.1     |    |  | $ | 10.3    |   
|Change in fair value                                  |  | $                     | (5.2    | )         |  |                |        |                |  | $ | 5.3     |    |  | $ | 10.5    |   
|Change as a percent of fair value                     |  |                       | n/m     |           |  |                |        |                |  |   | n/m     |    |  |   | n/m     |   



---



|    |                                                                                                                                   
|--- | ----------------------------------------------------------------------------------------------------------------------------------
|(1) | The fair value of the repurchase agreements would
    not change materially due to the short-term nature of these
    instruments.



| |                     
| | --------------------
| | n/m = not meaningful

It is important to note that the impact of
changing interest rates on fair value can change significantly
when interest rates change beyond 100 basis points from
current levels. Therefore, the volatility in the fair value of
our assets could increase significantly when interest rates
change beyond 100 basis points. In addition, other factors
impact the fair value of our interest rate-sensitive investments
and hedging instruments, such as the shape of the yield curve,
market expectations as to future interest rate changes and other
market conditions. Accordingly, in the event of changes in
actual interest rates, the change in the fair value of our
assets would likely differ from that shown above, and such
difference might be material and adverse to our stockholders.

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| |                
| | ---------------
| | Risk Management

To the extent consistent with maintaining our
REIT status, we seek to manage our interest rate risk exposure
to protect our portfolio of mortgage-backed securities and
related debt against the effects of major interest rate changes.
We generally seek to manage our interest rate risk by:



| |   |                                                                                                                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | monitoring and adjusting, if necessary, the reset
    index and interest rate related to our mortgage-backed
    securities and our borrowings;                                                                                                     
|
| |  | attempting to structure our borrowing agreements
    to have a range of different maturities, terms, amortizations
    and interest rate adjustment periods;                                                                                        
|
| |  | using derivatives, financial futures, swaps,
    options, caps, floors and forward sales, to adjust the interest
    rate sensitivity of our mortgage-backed securities and our
    borrowings; and                                                 
|
| |  | actively managing, on an aggregate basis, the
    interest rate indices, interest rate adjustment periods, and
    gross reset margins of our mortgage-backed securities and the
    interest rate indices and adjustment periods of our borrowings.

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|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

INDEX TO FINANCIAL STATEMENTS

Financial Statements of Luminent Mortgage
Capital, Inc.

|                                                                                                   |  |    |  | 
|-------------------------------------------------------------------------------------------------- |  | -- |  | 
|Balance Sheet as of December 31, 2003                                                              |  | 64 |  | 
|Statement of Operations for the period from
    April 26, 2003 through December 31, 2003           |  | 65 |  | 
|Statement of Stockholders Equity for the
    period from April 26, 2003 through December 31, 2003 |  | 66 |  | 
|Statement of Cash Flows for the period from
    April 26, 2003 through December 31, 2003           |  | 67 |  | 
|Notes to Financial Statements                                                                      |  | 68 |  | 
|Independent Auditors Report                                                                       |  | 84 |  | 

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LUMINENT MORTGAGE CAPITAL, INC.

BALANCE SHEET

|                                                   |                                                                                         |                                                                                                         |           |           |    | 
|-------------------------------------------------- | --------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------- | --------- | --------- | -- | 
|                                                   |                                                                                         | December 31,                                                                                           
|                                                   |                                                                                         | 2003                                                                                                   
|(in thousands, except share and per share amounts) |                                                                                         |                                                                                                        
|Assets:                                            |                                                                                         |                                                                                                         |           |          
|                                                   | Cash and cash equivalents                                                               |                                                                                                         | $         | 7,219     |   
|                                                   | Mortgage-backed securities available-for-sale, at
    fair value                        |                                                                                                         |           | 352,123   |   
|                                                   | Mortgage-backed securities available-for-sale,
    pledged as collateral, at fair value |                                                                                                         |           | 1,809,822 |   
|                                                   | Interest receivable                                                                     |                                                                                                         |           | 7,345     |   
|                                                   | Principal receivable                                                                    |                                                                                                         |           | 2,313     |   
|                                                   | Other assets                                                                            |                                                                                                         |           | 518       |   
|                                                   |                                                                                         |                                                                                                         |           |          
|Total assets                                       |                                                                                         | $                                                                                                       | 2,179,340 |          
|                                                   |                                                                                         |                                                                                                         |           |          
|Liabilities:                                       |                                                                                         |                                                                                                         |           |          
|                                                   | Repurchase agreements                                                                   |                                                                                                         | $         | 1,728,973 |   
|                                                   | Unsettled security purchases                                                            |                                                                                                         |           | 156,127   |   
|                                                   | Cash distribution payable                                                               |                                                                                                         |           | 5,267     |   
|                                                   | Futures contracts, at fair value                                                        |                                                                                                         |           | 157       |   
|                                                   | Accrued interest expense                                                                |                                                                                                         |           | 3,777     |   
|                                                   | Insurance note payable                                                                  |                                                                                                         |           | 92        |   
|                                                   | Accounts payable and accrued expenses                                                   |                                                                                                         |           | 1,363     |   
|                                                   | Management fee payable, incentive fee payable and
    other related party liabilities   |                                                                                                         |           | 1,088     |   
|                                                   |                                                                                         |                                                                                                         |           |          
|Total liabilities                                  |                                                                                         |                                                                                                         | 1,896,844 |          
|Stockholders Equity:                              |                                                                                         |                                                                                                         |           |          
|                                                   | Preferred stock, par value $0.001:                                                      |                                                                                                         |           |           |   
|                                                   |                                                                                         | 10,000,000 shares authorized; no shares
    issued and outstanding as of December 31, 2003              |           |           |   | 
|                                                   | Common stock, par value $0.001:                                                         |                                                                                                         |           |           |   
|                                                   |                                                                                         | 100,000,000 shares authorized;
    24,814,000 shares issued and outstanding as of
    December 31, 2003 |           |           | 25 | 
|                                                   | Additional paid-in capital                                                              |                                                                                                         |           | 317,339   |   
|                                                   | Accumulated other comprehensive loss                                                    |                                                                                                         |           | (26,510   | ) 
|                                                   | Accumulated distributions in excess of
    accumulated earnings                         |                                                                                                         |           | (8,358    | ) 
|                                                   |                                                                                         |                                                                                                         |           |          
|Total stockholders equity                         |                                                                                         |                                                                                                         | 282,496   |          
|                                                   |                                                                                         |                                                                                                         |           |          
|Total liabilities and stockholders equity         |                                                                                         | $                                                                                                       | 2,179,340 |          
|                                                   |                                                                                         |                                                                                                         |           |          

See notes to financial statements

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LUMINENT MORTGAGE CAPITAL, INC.

STATEMENT OF OPERATIONS

|                                                            |                                               |                     |            |        |        | 
|----------------------------------------------------------- | --------------------------------------------- | ------------------- | ---------- | ------ | ------ | 
|                                                            |                                               | For the Period     
|                                                            |                                               | from               
|                                                            |                                               | April 26, 2003     
|                                                            |                                               | through            
|                                                            |                                               | December 31,       
|                                                            |                                               | 2003               
|(in thousands, except share and per share amounts)          |                                               |                    
|Revenues:                                                   |                                               |                     |            |       
|Net interest income:                                        |                                               |                     |            |       
|                                                            | Interest income                               |                     | $          | 22,654 |       
|                                                            | Interest expense                              |                     |            | 9,009  |       
|                                                            |                                               |                     |            |       
|                                                            |                                               | Net interest income |            |        | 13,645 | 
|                                                            | Losses on sales of mortgage-backed securities |                     |            | (7,831 | )     
|Expenses:                                                   |                                               |                     |            |       
|                                                            | Management fee expense to related party       |                     |            | 901    |       
|                                                            | Incentive fee expense to related party        |                     |            | 980    |       
|                                                            | Salaries and benefits                         |                     |            | 99     |       
|                                                            | Professional services                         |                     |            | 477    |       
|                                                            | Board of directors expense                    |                     |            | 117    |       
|                                                            | Insurance expense                             |                     |            | 291    |       
|                                                            | Custody expense                               |                     |            | 115    |       
|                                                            | Other general and administrative expenses     |                     |            | 73     |       
|                                                            |                                               |                     |            |       
|Total expenses                                              |                                               |                     | 3,053      |       
|                                                            |                                               |                     |            |       
|Net income                                                  |                                               | $                   | 2,761      |       
|                                                            |                                               |                     |            |       
|Net income per share  basic                                |                                               | $                   | 0.27       |       
|                                                            |                                               |                     |            |       
|Net income per share  diluted                              |                                               | $                   | 0.27       |       
|                                                            |                                               |                     |            |       
|Weighted-average number of shares
    outstanding  basic   |                                               |                     | 10,139,280 |       
|                                                            |                                               |                     |            |       
|Weighted-average number of shares
    outstanding  diluted |                                               |                     | 10,139,811 |       
|                                                            |                                               |                     |            |       

See notes to financial statements

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LUMINENT MORTGAGE CAPITAL, INC.

STATEMENT OF STOCKHOLDERS
EQUITY

|                                                                         |  |                |        |            |  |             |    |               |  |             |         |               |  |       |         |   |  |   |         |   |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------ |  | -------------- | ------ | ---------- |  | ----------- | -- | ------------- |  | ----------- | ------- | ------------- |  | ----- | ------- | - |  | - | ------- | - |  | - | ------- | - |  | - | ------- | -
|                                                                         |  |                |        |            |  |             |    | Accumulated   |  |             |         |              
|                                                                         |  | Common Stock   |        |            |  | Accumulated |    | Distributions |  |             |         |              
|                                                                         |  |                |        | Additional |  | Other       |    | in Excess of  |  |             |         |              
|                                                                         |  |                |        | Par        |  | Paid-in     |    | Comprehensive |  | Accumulated |         | Comprehensive |  |      
|                                                                         |  | Shares         |        | Value      |  | Capital     |    | Loss          |  | Earnings    |         | Income/(Loss) |  | Total
|                                                                         |  |                |        |            |  |             |    |               |  |             |         |               |  |      
|                                                                         |  |               
|                                                                         |  | (In thousands)
|Balance, April 26, 2003                                                  |  |                | 204    |            |  | $           | 1  |               |  | $           |        |               |  | $     |        |   |  | $ |        |   |  | $ |        |   |  | $ | 1       |  
|Net income                                                               |  |                |        |            |  |             |    |               |  |             |         |               |  |       |         |   |  |   | 2,761   |   |  |   | 2,761   |   |  |   | 2,761   |  
|Mortgage-backed securities available-for-sale,
    fair value adjustment |  |                |        |            |  |             |    |               |  |             |         |               |  |       | (26,353 | ) |  |   |         |   |  |   | (26,353 | ) |  |   | (26,353 | )
|Futures contracts, fair value adjustment                                 |  |                |        |            |  |             |    |               |  |             |         |               |  |       | (157    | ) |  |   |         |   |  |   | (157    | ) |  |   | (157    | )
|                                                                         |  |                |        |            |  |             |    |               |  |             |         |               |  |       |         |   |  |   |         |   |  |   |         |   |  |   |         |  
|Comprehensive loss                                                       |  |                |        |            |  |             |    |               |  |             |         |               |  |       |         |   |  |   |         |   |  | $ | (23,749 | ) |  |   |         |  
|                                                                         |  |                |        |            |  |             |    |               |  |             |         |               |  |       |         |   |  |   |         |   |  |   |         |   |  |   |         |  
|Distributions to stockholders                                            |  |                |        |            |  |             |    |               |  |             |         |               |  |       |         |   |  |   | (11,119 | ) |  |   |         |   |  |   | (11,119 | )
|Issuance of common stock                                                 |  |                | 24,610 |            |  |             | 24 |               |  |             | 316,723 |               |  |       |         |   |  |   |         |   |  |   |         |   |  |   | 316,747 |  
|Capital contribution                                                     |  |                |        |            |  |             |    |               |  |             | 613     |               |  |       |         |   |  |   |         |   |  |   |         |   |  |   | 613     |  
|Capital contribution                                                     |  |                |        |            |  |             |    |               |  |             | 613     |               |  |       |         |   |  |   |         |   |  |   |         |   |  |   | 613     |  
|Amortization of stock options                                            |  |                |        |            |  |             |    |               |  |             | 3       |               |  |       |         |   |  |   |         |   |  |   |         |   |  |   | 3       |  
|                                                                         |  |                |        |            |  |             |    |               |  |             |         |               |  |       |         |   |  |   |         |   |  |   |         |   |  |   |         |  
|Balance, December 31, 2003                                               |  |                | 24,814 |            |  | $           | 25 |               |  | $           | 317,339 |               |  | $     | (26,510 | ) |  | $ | (8,358  | ) |  |   |         |   |  | $ | 282,496 |  
|                                                                         |  |                |        |            |  |             |    |               |  |             |         |               |  |       |         |   |  |   |         |   |  |   |         |   |  |   |         |  

See notes to financial statements

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LUMINENT MORTGAGE CAPITAL, INC.

STATEMENT OF CASH FLOWS

|                                                       |                                                                                        |                                                                                                   |                                           |            |       |            |  
|------------------------------------------------------ | -------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------- | ----------------------------------------- | ---------- | ----- | ---------- | -
|                                                       |                                                                                        | For the Period                                                                                   
|                                                       |                                                                                        | from                                                                                             
|                                                       |                                                                                        | April 26, 2003                                                                                   
|                                                       |                                                                                        | through                                                                                          
|(in thousands)                                         |                                                                                        | December 31,                                                                                     
|                                                       |                                                                                        | 2003                                                                                             
|                                                       |                                                                                        |                                                                                                  
|Cash flows from operating
    activities:              |                                                                                        |                                                                                                   |                                           |           
|                                                       | Net income                                                                             |                                                                                                   | $                                         | 2,761      |      
|                                                       | Adjustments to reconcile net income to net cash
    provided by operating activities:  |                                                                                                   |                                           |            |      
|                                                       | Amortization of premium/ discount on
    mortgage-backed securities available-for-sale |                                                                                                   |                                           | 9,189      |      
|                                                       | Amortization of stock options                                                          |                                                                                                   |                                           | 3          |      
|                                                       | Losses on sales of mortgage-backed securities                                          |                                                                                                   |                                           | 7,831      |      
|                                                       | Incentive fee waived by related party                                                  |                                                                                                   |                                           | 613        |      
|                                                       | Changes in operating assets and liabilities:                                           |                                                                                                   |                                           |            |      
|                                                       |                                                                                        | Increase in interest receivable, net of purchased
    interest                                    |                                           |            | (116  | )         
|                                                       |                                                                                        | Increase in other assets                                                                          |                                           |            | (518  | )         
|                                                       |                                                                                        | Increase in accounts payable and accrued expenses                                                 |                                           |            | 1,363 |           
|                                                       |                                                                                        | Increase in interest payable                                                                      |                                           |            | 3,777 |           
|                                                       |                                                                                        | Increase in management fee payable, incentive fee
    payable and other related party liabilities |                                           |            | 1,088 |           
|                                                       |                                                                                        |                                                                                                   |                                           |           
|                                                       |                                                                                        |                                                                                                   | Net cash provided by operating activities |            |       | 25,991     |  
|                                                       |                                                                                        |                                                                                                   |                                           |           
|Cash flows from investing
    activities:              |                                                                                        |                                                                                                   |                                           |           
|                                                       | Purchase of mortgage-backed securities
    available-for-sale                          |                                                                                                   |                                           | (2,797,073 | )    
|                                                       | Proceeds from sales of mortgage-backed securities                                      |                                                                                                   |                                           | 538,780    |      
|                                                       | Principal payments of mortgage-backed securities                                       |                                                                                                   |                                           | 199,560    |      
|                                                       |                                                                                        |                                                                                                   |                                           |           
|                                                       |                                                                                        |                                                                                                   | Net cash used in investing activities     |            |       | (2,058,733 | )
|                                                       |                                                                                        |                                                                                                   |                                           |           
|Cash flows from financing
    activities:              |                                                                                        |                                                                                                   |                                           |           
|                                                       | Net proceeds from issuance of common stock                                             |                                                                                                   |                                           | 316,747    |      
|                                                       | Borrowings under repurchase agreements                                                 |                                                                                                   |                                           | 10,097,957 |      
|                                                       | Principal payments on repurchase agreements                                            |                                                                                                   |                                           | (8,368,984 | )    
|                                                       | Payment of cash distributions                                                          |                                                                                                   |                                           | (5,852     | )    
|                                                       | Borrowings under margin loan                                                           |                                                                                                   |                                           | 4,266      |      
|                                                       | Paydown of margin loan                                                                 |                                                                                                   |                                           | (4,266     | )    
|                                                       | Borrowings under note payable, net                                                     |                                                                                                   |                                           | 92         |      
|                                                       |                                                                                        |                                                                                                   |                                           |           
|                                                       |                                                                                        |                                                                                                   | Net cash provided by financing activities |            |       | 2,039,960  |  
|                                                       |                                                                                        |                                                                                                   |                                           |           
|Net increase in cash and cash
    equivalents          |                                                                                        |                                                                                                   | 7,218                                     |           
|Cash and cash equivalents, beginning of the
    period |                                                                                        |                                                                                                   | 1                                         |           
|                                                       |                                                                                        |                                                                                                   |                                           |           
|Cash and cash equivalents, end of the
    period       |                                                                                        | $                                                                                                 | 7,219                                     |           
|                                                       |                                                                                        |                                                                                                   |                                           |           
|Supplemental disclosure of cash flow
    information:  |                                                                                        |                                                                                                   |                                           |           
|                                                       | Interest paid                                                                          |                                                                                                   | $                                         | 5,222      |      
|Non-cash investing activity:                           |                                                                                        |                                                                                                   |                                           |           
|                                                       | Increase in unsettled security purchases                                               |                                                                                                   | $                                         | 156,127    |      
|                                                       | Increase in principal receivable                                                       |                                                                                                   |                                           | (2,313     | )    

See notes to financial statements

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LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO FINANCIAL STATEMENTS

Note 1  Organization

Luminent Mortgage Capital, Inc., or the Company,
was organized as a Maryland corporation on April 25, 2003.
The Company commenced its operations of purchasing and holding
an investment portfolio of mortgage-backed securities on
June 11, 2003, upon completion of a private placement
offering. On December 18, 2003, the Company completed the
initial public offering of its shares of common stock and began
trading on the New York Stock Exchange under the trading
symbol LUM on December 19, 2003.

Seneca Capital Management LLC, or the Manager,
pursuant to a management agreement, or the Management Agreement,
manages the Company and its investment portfolio. See
Note 7 for further discussion on the Management Agreement.

The Company intends to elect to be taxed as a
Real Estate Investment Trust, or REIT, and to comply with the
provisions of the Internal Revenue Code, or the Code, with
respect thereto. See Note 2 for further discussion on
income taxes.

Note 2  Accounting
Policies



| |                          
| | -------------------------
| | Cash and Cash Equivalents

Cash and cash equivalents include cash on hand
and highly liquid investments with maturities of three months or
less at the time of purchase. The carrying amount of cash
equivalents approximates their fair value. The Companys
primary bank account is a sweep account with the custodian bank.

Securities

The Company invests primarily in U.S. agency
and other highly-rated, single-family, adjustable-rate, hybrid
adjustable-rate and fixed-rate mortgage-backed securities issued
in the United States market.

The Company classifies its investments as either
trading, available-for-sale or held-to-maturity securities.
Management determines the appropriate classification of the
securities at the time they are acquired and evaluates the
appropriateness of such classifications at each balance sheet
date. The Company currently classifies all of its securities as
available-for-sale. All assets that are classified as
available-for-sale are carried at fair value and unrealized
gains or losses are included in accumulated other comprehensive
loss as a component of stockholders equity. The fair
values of mortgage-backed securities are determined by
management based upon price estimates provided by independent
pricing services and securities dealers. In the event that a
security becomes impaired (e.g., if the fair value falls below
the amortized cost basis and recovery is not expected before the
security is sold), the cost of the security would be written
down and the difference would be reflected in current earnings.
The determination of other-than-temporary impairment is
evaluated at least quarterly.

Interest income is accrued based upon the
outstanding principal amount of the securities and their
contractual terms. Premiums and discounts are amortized or
accreted into interest income over the lives of the securities
using the effective yield method adjusted for the effects of
estimated prepayments based on Statement of Financial Accounting
Standards, or SFAS, No. 91, Accounting for Nonrefundable
Fees and Costs Associated with Originating or Acquiring Loans
and Initial Direct Costs of Leases.

Security transactions are recorded on the trade
date. Realized gains and losses from security transactions are
determined based upon the specific identification method.

Derivative Financial Instruments

The Company may enter into derivative contracts,
including futures contracts and interest rate swaps, as a means
of mitigating the Companys interest rate risk on
forecasted interest expense associated with

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

the benchmark rate on forecasted
rollover/reissuance of repurchase agreements, or hedged items,
for a specified future time period. The Company has designated
these transactions as cash flow hedges. The contracts, or hedge
instruments, are evaluated at inception and on an on-going basis
in order to determine whether they qualify for hedge accounting
under SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, as amended and
interpreted. The hedge instrument must be highly effective in
achieving offsetting changes in the hedged item attributable to
the risk being hedged in order to qualify for hedge accounting.
Derivative contracts are carried on the balance sheet at fair
value. Any ineffectiveness which arises during the hedging
relationship, is recognized in interest expense during the
period in which it arises. Prior to the end of the specified
hedge time period the effective portion of all contract gains
and losses (whether realized or unrealized) is recorded in other
comprehensive income or loss. Realized gains and losses are
reclassified into earnings as an adjustment to interest expense
during the specified hedge time period.

Repurchase Agreements

The Company finances the acquisition of its
securities primarily through the use of repurchase agreements.
Repurchase agreements are treated as collateralized financing
transactions and are carried at their contractual amounts,
including accrued interest, as specified in the respective
agreements. Accrued interest on repurchase agreements is
recorded as a separate line item on the balance sheet.

Income Taxes

The Company intends to elect to be taxed as a
REIT and to comply with the provisions of the Code with respect
thereto. Accordingly, the Company is not subject to Federal or
state income tax to the extent that its distributions to
stockholders satisfy the REIT requirements and certain asset,
income and stock ownership tests are met.

Distributions declared per share were $0.95 for
the period from April 26, 2003 through December 31,
2003. All distributions were classified as ordinary income to
stockholders for income tax purposes.

Stock Compensation

As of December 31, 2003, the Company had
55,000 outstanding stock options, and intends to issue stock
options in the future. Such options may be issued to Company
employees and directors, and to employees of the Manager. The
Company accounts for stock options issued to its own employees
and directors using the fair value based methodology prescribed
by SFAS No. 123, Accounting for Stock-Based
Compensation. Stock options issued to employees of the
Manager will be recognized as expense over the vesting period
based on their fair value.

Incentive Compensation

The Company has a Management Agreement that
provides for the payment of an incentive fee to the Manager if
the Companys financial performance exceeds certain
benchmarks. See Note 7 for further discussion on the
specific terms of the computation and payment of the incentive
fee.

The cash portion of the incentive fee is accrued
and expensed during the period for which it is calculated and
earned. The Company accounts for the restricted stock portion of
the incentive fee in accordance with SFAS No. 123, and
related interpretations, and Emerging Issues Task Force, or
EITF, 96-18, Accounting for Equity Instruments That Are
Issued to Other Than Employees for Acquiring, or in Conjunction
with Selling, Goods or Services.

In accordance with the consensus on Issue 1 in
EITF 96-18, the measurement date of the shares issued for
incentive compensation is the date when the Managers
performance is complete. Since

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

continuing service is required in order for the
restrictions on issued shares to lapse and for ownership to
vest, for each one-third tranche (based on varying
restriction/vesting periods) of shares issued for a given
period, performance is considered to be complete when the
restriction period for that tranche ends and ownership
vests. The period over which the stock is earned by the Manager
(i.e., the period during which services are provided before the
stock vests) is both the period during which the incentive
compensation was initially calculated and the vesting period for
each tranche issued. Therefore, expense for the stock portion of
incentive fees issued for a given period is spread over five
quarters for the first tranche (shares vesting one year after
issuance), nine quarters for the second tranche (shares vesting
two years after issuance), and 13 quarters for the third
tranche. In accordance with the consensus on Issue 2 in EITF
96-18, the fair value of the shares issued is recognized in the
same manner as if the Company had paid cash to the Manager for
its services. When the shares are issued, they are recorded at
the then-current fair value in stockholders equity, with
an offsetting entry to deferred compensation (a contra-equity
account). The deferred compensation account is reduced and
expense is recognized quarterly up to the measurement date, as
discussed above. In accordance with the consensus in Issue 3 of
EITF 96-18, fair value is adjusted quarterly for unvested
shares, and changes in such fair value each quarter are
reflected in the expense recognized in that quarter and in
future quarters. By the end of the quarter in which performance
is complete (i.e., the measurement date), the deferred
compensation account is reduced to zero and there are no further
adjustments to equity for changes in fair value of the shares.

The Company also pays an incentive fee, in the
form of cash and restricted stock, to the Companys Chief
Financial Officer, in accordance with the terms of his
employment agreement. The incentive fee is accounted for in the
same manner as the incentive fee earned by the Manager.

Net Income Per Share

The Company calculates basic earnings per share
by dividing net income for the period by weighted-average shares
of its common stock outstanding for that period. Diluted
earnings per share takes into account the effect of dilutive
instruments, such as stock options, but uses the average share
price for the period in determining the number of incremental
shares that are to be added to the weighted-average number of
shares outstanding.

Use of Estimates

The preparation of financial statements in
conformity with accounting principles generally accepted in the
United States of America requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Actual
results could differ from those estimates. Estimates affecting
the accompanying financial statements include the fair values of
mortgage-backed securities and the prepayment speeds used to
calculate amortization and accretion of premiums and discounts
on mortgage-backed securities.

Concentrations of Credit Risk and Other Risks
and Uncertainties

The Companys investments are concentrated
in securities that pass through collections of principal and
interest from underlying mortgages, and there is a risk that
some borrowers on the underlying mortgages will default.
Therefore, mortgage-backed securities may bear some exposure to
credit losses. However, the Company mitigates credit risk by
holding securities that are either guaranteed by government or
government-sponsored agencies or have credit ratings of AAA or
higher. As of December 31, 2003, 63% of the Companys
mortgage-backed securities portfolio, as measured by its fair
value, was agency-guaranteed.

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

The Company bears certain other risks typical in
investing in a portfolio of mortgage-backed securities.
Principal risks potentially affecting the Companys
financial position, results of operations and cash flows include
the risks that: (a) interest rate changes can negatively
affect the market value of the Companys mortgage-backed
securities, (b) interest rate changes can influence
decisions made by borrowers on the mortgages underlying the
securities to prepay those mortgages, which can negatively
affect both cash flows from, and the market value of, the
securities, and (c) adverse changes in the market value of
the Companys mortgage-backed securities and/or the
inability of the Company to renew short-term borrowings can
result in the need to sell securities at inopportune times and
incur realized losses.

Recent Accounting Pronouncements

As of December 31, 2003, the Company has
adopted early all relevant accounting standards that have been
issued by authoritative bodies in the United States and for
which adoption is not yet required. Therefore, the Company does
not anticipate that comparability of its financial statements
for future periods to the financial statements for the
historical periods presented herein will be affected by any
recently-issued accounting pronouncements.

In April 2003, the Financial Accounting Standards
Board, or FASB, issued SFAS No. 149, Amendment of
Statement 133 on Derivative Instruments and Hedging
Activities. This Statement amends and clarifies financial
accounting and reporting for derivative instruments, including
certain derivative instruments embedded in other contracts and
for hedging activities under SFAS No. 133. The changes
in this Statement improve financial reporting by requiring that
contracts with comparable characteristics be accounted for
similarly. SFAS No. 149 was effective for contracts entered
into or modified after June 30, 2003, except as stated
below, and for hedging relationships designated after
June 30, 2003. All provisions of SFAS No. 149
should be applied prospectively, except for as prescribed by the
Statement. In addition, the provisions of SFAS No. 149 that
relate to forward purchases or sales of when-issued securities
or other securities that do not yet exist should be applied to
both existing contracts and new contracts entered into after
June 30, 2003. Adoption of this Statement did not have a
material impact on the Companys financial position or
results of operations.

In May 2003, the FASB issued
SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and
Equity. The Statement establishes standards for how the
Company should classify and measure certain financial
instruments with characteristics of both liabilities and equity.
SFAS No. 150 is effective for financial instruments
entered into or modified after May 31, 2003, and was
otherwise generally effective at the beginning of the first
interim period beginning after June 15, 2003. Adoption of
this Statement did not have a material impact on the
Companys financial position or results of operations.

In December 2003, the FASB issued Interpretation,
or FIN 46R, Consolidation of Variable Interest
Entities. The purpose of this interpretation is to provide
guidance on how to identify a variable interest entity, or VIE,
and determine when the assets, liabilities, noncontrolling
interests, and results of operations of a VIE need to be
included in a companys consolidated financial statements.
A company that holds variable interests in an entity will need
to consolidate that entity if the companys interest in the
VIE is such that the company will absorb a majority of the
VIEs expected losses and/or receive a majority of the
VIEs expected residual returns. New disclosure
requirements are also prescribed by FIN 46R. Adoption of
this Statement did not have a material impact on the
Companys financial position or results of operations.

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

Note 3  Mortgage-Backed
Securities

The following table summarizes the Companys
mortgage-backed securities classified as available-for-sale as
of December 31, 2003, which are carried at fair value:

|                  |  |                 |         |                 |  |            |           |                 |  |   |        |   |  |   |           |  
|----------------- |  | --------------- | ------- | --------------- |  | ---------- | --------- | --------------- |  | - | ------ | - |  | - | --------- | -
|                  |  |                 |         | Hybrid          |  | Balloon    |           | Total Mortgage-
|                  |  | Adjustable-     |         | Adjustable-Rate |  | Maturity   |           | Backed         
|                  |  | Rate Securities |         | Securities      |  | Securities |           | Securities     
|                  |  |                 |         |                 |  |            |           |                
|                  |  |                
|                  |  | (In thousands) 
|Amortized cost    |  | $               | 187,769 |                 |  | $          | 1,944,707 |                 |  | $ | 55,822 |   |  | $ | 2,188,298 |  
|Unrealized gains  |  |                 | 7       |                 |  |            | 1,061     |                 |  |   |       |   |  |   | 1,068     |  
|Unrealized losses |  |                 | (2,463  | )               |  |            | (23,828   | )               |  |   | (1,130 | ) |  |   | (27,421   | )
|                  |  |                 |         |                 |  |            |           |                 |  |   |        |   |  |   |           |  
|Fair value        |  | $               | 185,313 |                 |  | $          | 1,921,940 |                 |  | $ | 54,692 |   |  | $ | 2,161,945 |  
|                  |  |                 |         |                 |  |            |           |                 |  |   |        |   |  |   |           |  
|% of total        |  |                 | 8.6     | %               |  |            | 88.9      | %               |  |   | 2.5    | % |  |   | 100.0     | %

Actual maturities of mortgage-backed securities
are generally shorter than stated contractual maturities. Actual
maturities of the Companys mortgage-backed securities are
affected by the contractual lives of the underlying mortgages,
periodic payments of principal, and prepayments of principal.
The following table summarizes the Companys
mortgage-backed securities on December 31, 2003 according
to their estimated weighted-average life classifications:

|                                               |  |                |           |                |  |           |           |  |  |  |      |  
|---------------------------------------------- |  | -------------- | --------- | -------------- |  | --------- | --------- |  |  |  | ---- | -
|                                               |  |                |           |                |  | Weighted-
|                                               |  |                |           | Amortized      |  | Average  
|Weighted-Average Life                          |  | Fair Value     |           | Cost           |  | Coupon   
|                                               |  |                |           |                |  |          
|                                               |  | (In thousands) |           | (In thousands) |  |          
|Less than one year                             |  | $              | 299,685   |                |  | $         | 304,556   |  |  |  | 4.07 | %
|Greater than one year and less than five years |  |                | 1,829,471 |                |  |           | 1,850,899 |  |  |  | 4.09 |  
|Greater than five years                        |  |                | 32,789    |                |  |           | 32,843    |  |  |  | 3.96 |  
|                                               |  |                |           |                |  |           |           |  |  |  |      |  
|Total                                          |  | $              | 2,161,945 |                |  | $         | 2,188,298 |  |  |  | 4.09 | %
|                                               |  |                |           |                |  |           |           |  |  |  |      |  

The weighted-average lives of the mortgage-backed
securities at December 31, 2003 in the table above are
based upon data provided through subscription-based financial
information services, assuming constant principal prepayment
rates to the balloon or reset date for each security. The
prepayment model considers current yield, forward yield,
steepness of the yield curve, current mortgage rates, mortgage
rate of the outstanding loan, loan age, margin and volatility.

The actual weighted-average lives of the
mortgage-backed securities in the Companys investment
portfolio could be longer or shorter than the estimates in the
table above depending on the actual prepayment rates experienced
over the lives of the applicable securities and are sensitive to
changes in both prepayment rates and interest rates.

During the period from April 26, 3003
through December 31, 2003, the Company sold securities
totaling $130.7 million and realized a loss of
$2.3 million. The Company also sold short $200 million
of to be announced mortgage securities. The Company
closed out this short position for a total realized loss of
$5.7 million. The Company also simultaneously sold and
purchased securities totaling $215.9 million and
$215.7 million, respectively, that resulted in a realized
gain on sale of $0.2 million.

At December 31, 2003, unsettled security
purchases totaled $156.1 million. These purchases settled
in January 2004.

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

The following table shows the Companys
investments fair value and gross unrealized losses,
aggregated by investment category and length of time that
individual securities have been in a continuous unrealized loss
position, at December 31, 2003:

|                                             |  |                     |           |                   |  |       |         |            |  |       |   |            |  |   |   |  |  |   |           |  |  |   |         |  
|-------------------------------------------- |  | ------------------- | --------- | ----------------- |  | ----- | ------- | ---------- |  | ----- | - | ---------- |  | - | - |  |  | - | --------- |  |  | - | ------- | -
|                                             |  |                     |           |                   |  |      
|                                             |  | Less than 12 Months |           | 12 Months or More |  | Total
|                                             |  |                     |           |                   |  |      
|                                             |  |                     |           | Gross             |  |       |         | Gross      |  |       |   | Gross     
|                                             |  | Fair                |           | Unrealized        |  | Fair  |         | Unrealized |  | Fair  |   | Unrealized
|                                             |  | Value               |           | Losses            |  | Value |         | Losses     |  | Value |   | Losses    
|                                             |  |                     |           |                   |  |       |         |            |  |       |   |           
|                                             |  |                    
|                                             |  | (In thousands)     
|Agency-backed mortgage-backed securities     |  | $                   | 1,109,858 |                   |  | $     | (17,261 | )          |  | $     |  |            |  | $ |  |  |  | $ | 1,109,858 |  |  | $ | (17,261 | )
|Non-agency-backed mortgage-backed securities |  |                     | 644,448   |                   |  |       | (10,160 | )          |  |       |  |            |  |   |  |  |  |   | 644,448   |  |  |   | (10,160 | )
|                                             |  |                     |           |                   |  |       |         |            |  |       |   |            |  |   |   |  |  |   |           |  |  |   |         |  
|Total temporarily impaired securities        |  | $                   | 1,754,306 |                   |  | $     | (27,421 | )          |  | $     |  |            |  | $ |  |  |  | $ | 1,754,306 |  |  | $ | (27,421 | )
|                                             |  |                     |           |                   |  |       |         |            |  |       |   |            |  |   |   |  |  |   |           |  |  |   |         |  

At December 31, 2003, the Company was only
invested in AAA-rated non-agency-backed or agency-backed
mortgage-backed securities. The temporary impairment of the
available-for-sale securities results from the fair value of the
securities falling below the amortized cost basis. As of
December 31, 2003, none of the securities held had been
downgraded by a credit rating agency since their purchase.
Management intends to hold the securities until maturity,
allowing for the anticipated recovery in fair value of the
securities held. As such, management does not believe any of
securities held are other-than-temporarily impaired at
December 31, 2003.

Note 4  Repurchase Agreements
and Other Borrowings

The Company has entered into repurchase
agreements with third party financial institutions to finance
most of its mortgage-backed securities. The repurchase
agreements are short-term borrowings that bear interest rates
that have historically moved in close relationship to the
three-month London Interbank Offered Rate, or LIBOR. At
December 31, 2003, the Company had an outstanding amount of
$1.7 billion with weighted-average borrowing rates of
1.19%. At December 31, 2003 securities pledged as
collateral for repurchase agreements had estimated fair values
of $1.8 billion.

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

At December 31, 2003, the repurchase
agreements had remaining maturities as summarized below:

|                                                  |                                                                       |           |   |          |   |           |   |              |   |       |   |         |   |  |   |           |   |  |   |           |  
|------------------------------------------------- | --------------------------------------------------------------------- | --------- | - | -------- | - | --------- | - | ------------ | - | ----- | - | ------- | - |  | - | --------- | - |  | - | --------- | -
|                                                  |                                                                       | Overnight |   | Between  |   | Between   |   |              |   |      
|                                                  |                                                                       | (1 day or |   | 2 and 30 |   | 31 and 90 |   | Greater than |   |      
|                                                  |                                                                       | less)     |   | days     |   | days      |   | 90 days      |   | Total
|(In thousands)                                    |                                                                       |           |   |          |   |           |   |              |   |      
|Agency-backed mortgage-backed
    securities:     |                                                                       |           |   |          |   |           |   |              |   |       |   |         |   |  |   |           |   |  |   |          
|                                                  | Amortized cost of securities sold, including
    accrued interest     |           | $ |         |   |           | $ | 14,299       |   |       | $ | 302,538 |   |  | $ | 1,010,586 |   |  | $ | 1,327,423 |  
|                                                  | Fair market value of securities sold, including
    accrued interest  |           |   |         |   |           |   | 14,065       |   |       |   | 302,272 |   |  |   | 994,545   |   |  |   | 1,310,882 |  
|                                                  | Repurchase agreement liabilities associated with
    these securities |           |   |         |   |           |   | 12,865       |   |       |   | 281,870 |   |  |   | 952,532   |   |  |   | 1,247,267 |  
|                                                  | Average interest rate of repurchase agreement
    liabilities         |           |   | 0.00     | % |           |   | 1.20         | % |       |   | 1.11    | % |  |   | 1.19      | % |  |   | 1.17      | %
|Non-agency-backed mortgage-backed
    securities: |                                                                       |           |   |          |   |           |   |              |   |       |   |         |   |  |   |           |   |  |   |          
|                                                  | Amortized cost of securities sold, including
    accrued interest     |           | $ | 18,475   |   |           | $ | 329,592      |   |       | $ |        |   |  | $ | 165,608   |   |  | $ | 513,675   |  
|                                                  | Fair market value of securities sold, including
    accrued interest  |           |   | 18,431   |   |           |   | 324,769      |   |       |   |        |   |  |   | 161,881   |   |  |   | 505,081   |  
|                                                  | Repurchase agreement liabilities associated with
    these securities |           |   | 17,490   |   |           |   | 306,911      |   |       |   |        |   |  |   | 157,305   |   |  |   | 481,706   |  
|                                                  | Average interest rate of repurchase agreement
    liabilities         |           |   | 1.20     | % |           |   | 1.21         | % |       |   | 0.00    | % |  |   | 1.29      | % |  |   | 1.23      | %
|Total:                                            |                                                                       |           |   |          |   |           |   |              |   |       |   |         |   |  |   |           |   |  |   |          
|                                                  | Amortized cost of securities sold, including
    accrued interest     |           | $ | 18,475   |   |           | $ | 343,891      |   |       | $ | 302,538 |   |  | $ | 1,176,194 |   |  | $ | 1,841,098 |  
|                                                  | Fair market value of securities sold, including
    accrued interest  |           |   | 18,431   |   |           |   | 338,834      |   |       |   | 302,272 |   |  |   | 1,156,426 |   |  |   | 1,815,963 |  
|                                                  | Repurchase agreement liabilities associated with
    these securities |           |   | 17,490   |   |           |   | 319,776      |   |       |   | 281,870 |   |  |   | 1,109,837 |   |  |   | 1,728,973 |  
|                                                  | Average interest rate of repurchase agreement
    liabilities         |           |   | 1.20     | % |           |   | 1.21         | % |       |   | 1.11    | % |  |   | 1.20      | % |  |   | 1.19      | %

At December 31, 2003, the repurchase
agreements had the following counterparties, amounts at risk and
weighted-average remaining maturities:

|                                                                                        |  |                |        |                    |  |  |     | 
|--------------------------------------------------------------------------------------- |  | -------------- | ------ | ------------------ |  |  | --- | 
|                                                                                        |  |                |        | Weighted-Average  
|                                                                                        |  |                |        | Maturity of       
|                                                                                        |  | Amount at      |        | Repurchase        
|Repurchase Agreement Counterparties                                                     |  | Risk(1)        |        | Agreements in Days
|                                                                                        |  |                |        |                   
|                                                                                        |  | (In thousands) |        |                   
|Bear Stearns & Co.                                                                      |  | $              | 8,423  |                    |  |  | 138 | 
|Banc of America Securities LLC                                                          |  |                | 9,762  |                    |  |  | 26  | 
|Countrywide Securities Corporation                                                      |  |                | 2,358  |                    |  |  | 23  | 
|Credit Suisse First Boston LLC                                                          |  |                | 14,350 |                    |  |  | 130 | 
|Deutsche Bank Securities Inc.                                                           |  |                | 2,350  |                    |  |  | 146 | 
|Federal Home Loan Mortgage Corporation                                                  |  |                | (279   | )                  |  |  | 61  | 
|Goldman Sachs & Co.                                                                     |  |                | (390   | )                  |  |  | 58  | 
|J.P. Morgan Securities Inc.                                                             |  |                | 1,649  |                    |  |  | 177 | 
|Merrill Lynch Government Securities Inc./ Merrill
    Lynch Pierce, Fenner & Smith Inc. |  |                | 6,352  |                    |  |  | 189 | 
|Morgan Stanley & Co. Inc.                                                               |  |                | 972    |                    |  |  | 61  | 
|Salomon Smith Barney                                                                    |  |                | 20,287 |                    |  |  | 163 | 
|UBS Securities LLC                                                                      |  |                | 17,379 |                    |  |  | 189 | 
|                                                                                        |  |                |        |                    |  |  |     | 
|Total                                                                                   |  | $              | 83,213 |                    |  |  | 145 | 
|                                                                                        |  |                |        |                    |  |  |     | 



---



|    |                                                                                                                                                         
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Equal to the fair value of securities sold, plus
    accrued interest income, minus repurchase agreement liabilities,
    plus accrued interest expense.

74



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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

The Company had a note payable of $92 thousand at
December 31, 2003 for the purpose of financing its annual
directors and officers insurance premium at an
interest rate of 6.5%.

The Company has a margin lending facility with
its primary custodian where it may borrow money in connection
with the purchase or sale of securities. The terms of the
borrowings, including the rate of interest payable, are agreed
to with the custodian for each amount borrowed. Borrowings are
repayable immediately upon demand of the custodian. At
December 31, 2003, there were no outstanding borrowings
under the margin lending facility.



|         |                                     
|-------- | ------------------------------------
|Note 5  | Capital Stock and Earnings Per Share

The Company had 100,000,000 shares of par
value $0.001 common stock authorized and 24,814,000 shares
outstanding as of December 31, 2003. The Company had
10,000,000 shares of par value $0.001 preferred stock
authorized and none outstanding as of December 31, 2003.

In two closings on June 11 and June 19,
2003, the Company completed a private offering of
11,092,473 shares of common stock, $0.001 par value at
an offering price of $15.00 per share, including the
exercise by the initial purchaser/placement agent of its
over-allotment option to purchase 1,500,000 shares of
common stock. In addition, on June 11, 2003 the Company
issued 407,527 shares of common stock, par value $0.001, at
an offering price net of the initial purchasers discount
of $13.95 per share, to employees and affiliates of the
Manager, and other persons selected by the Manager. The Company
received proceeds from these transactions in the amount of
$159.7 million, net of underwriting discount and other
offering costs.

On December 18, 2003, the Company completed
an initial public offering of 13,110,000 shares common
stock, $0.001 par value at an offering price of
$13.00 per share, including the exercise by the underwriter
of its over-allotment option to purchase 1,710,000 shares
of common stock. The Company received proceeds from the initial
public offering in the amount of $157.0 million, net of
underwriting discount and other offering costs.

The Company filed a resale shelf registration
statement with the SEC with respect to up to
11,500,000 shares of its common stock issued in the
June 11, 2003 and June 19, 2003 private offerings. The
registration statement was declared effective by the SEC on
February 13, 2004.

The following table presents a reconciliation of
basic and diluted earnings per share for the period from
April 26, 2003 through December 31, 2003:

|                                                                  |                                              |       |            |         |  |   |            |     | 
|----------------------------------------------------------------- | -------------------------------------------- | ----- | ---------- | ------- |  | - | ---------- | --- | 
|                                                                  |                                              | Basic |            | Diluted
|                                                                  |                                              |       |            |        
|Net income (in thousands)                                         |                                              | $     | 2,761      |         |  | $ | 2,761      |    
|Weighted-average number of common shares
    outstanding          |                                              |       | 10,139,280 |         |  |   | 10,139,280 |    
|Additional shares due to:                                         |                                              |       |            |         |  |   |            |    
|                                                                  | Assumed conversion of dilutive stock options |       |            |        |  |   |            | 531 | 
|                                                                  |                                              |       |            |         |  |   |            |    
|Adjusted weighted-average number of common shares
    outstanding |                                              |       | 10,139,280 |         |  |   | 10,139,811 |    
|                                                                  |                                              |       |            |         |  |   |            |    
|Net income per share                                              |                                              | $     | 0.27       |         |  | $ | 0.27       |    
|                                                                  |                                              |       |            |         |  |   |            |    



|         |                           
|-------- | --------------------------
|Note 6  | 2003 Stock Incentive Plans

The Company adopted a 2003 Stock Incentive Plan,
effective June 4, 2003, and a 2003 Outside Advisors Stock
Incentive Plan, effective June 4, 2003, pursuant to which
up to 1,000,000 shares of the Companys common stock
is authorized to be awarded at the discretion of the
Compensation Committee of the Board of Directors. The plans
provide for the grant of a variety of long-term incentive awards
to

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

employees and officers of the Company, individual
consultants or advisors who render or have rendered bona fide
services, and officers, employees or directors of the Manager as
an additional means to attract, motivate, retain and reward
eligible persons. These plans provide for the grant of awards
that meet the requirements of Section 422 of the Code,
non-qualified stock options, stock appreciation rights,
restricted stock, stock units and other stock-based awards, and
dividend equivalent rights. The maximum term of each grant is
determined on the grant date by the Compensation Committee and
shall not exceed 10 years. The exercise price and the
vesting requirement of each grant is determined on the grant
date by the Compensation Committee.

The following table illustrates the stock options
available for grant as of December 31, 2003:

|                             |  |                |        |                |  |       |     |     |  |  |           |    
|---------------------------- |  | -------------- | ------ | -------------- |  | ----- | --- | --- |  |  | --------- | ---
|                             |  |                |        | 2003 Outside   |  |      
|                             |  | 2003 Stock     |        | Advisors Stock |  |      
|                             |  | Incentive Plan |        | Incentive Plan |  | Total
|                             |  |                |        |                |  |      
|Shares reserved for issuance |  |                | n/a    | (1)            |  |       | n/a | (1) |  |  | 1,000,000 | (1)
|Granted                      |  |                | 55,000 |                |  |       |    |     |  |  | 55,000    |    
|Forfeited                    |  |                |       |                |  |       |    |     |  |  |          |    
|Expired                      |  |                |       |                |  |       |    |     |  |  |          |    
|                             |  |                |        |                |  |       |     |     |  |  |           |    
|Total available for grant    |  |                | n/a    | (2)            |  |       | n/a | (2) |  |  | 945,000   | (2)
|                             |  |                |        |                |  |       |     |     |  |  |           |    



---



|    |                                                                                                                                                                                                                        
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | At June 4, 2003, adoption date of both stock
    incentive plans, the maximum number of shares of common stock
    that may be delivered pursuant to awards granted under these
    combined plans is 1,000,000 shares.
|   
|(2) | At December 31, 2003, the maximum number of
    shares of common stock that may be delivered pursuant to awards
    granted under these combined plans is 945,000 shares.                                              

At December 31, 2003, the Company had
outstanding options under the plans with expiration dates of
2013, as illustrated in the following table:

|                                 |  |           |        |                  |  |   |       | 
|-------------------------------- |  | --------- | ------ | ---------------- |  | - | ----- | 
|                                 |  | Number of |        | Weighted-Average
|                                 |  | Options   |        | Exercise Price  
|                                 |  |           |        |                 
|Outstanding at April 26, 2003    |  |           |       |                  |  |   |      | 
|Granted                          |  |           | 55,000 |                  |  | $ | 14.82 | 
|Exercised                        |  |           |       |                  |  |   |      | 
|Forfeited                        |  |           |       |                  |  |   |      | 
|                                 |  |           |        |                  |  |   |       | 
|Outstanding at December 31, 2003 |  |           | 55,000 |                  |  | $ | 14.82 | 
|                                 |  |           |        |                  |  |   |       | 

The following table illustrates information about
stock options outstanding at December 31, 2003:

|                |  |             |        |                  |  |                  |     |           |  |                  |       |  |  |  |   |  |  |  |   | 
|--------------- |  | ----------- | ------ | ---------------- |  | ---------------- | --- | --------- |  | ---------------- | ----- |  |  |  | - |  |  |  | - | 
|                |  |             |        |                 
|                |  | Outstanding |        | Exercisable     
|                |  |             |        |                 
|                |  |             |        | Weighted-Average |  |                  |     |          
|Range of        |  | Number of   |        | Remaining Life   |  | Weighted-Average |     | Number of |  | Weighted-Average
|Exercise Prices |  | Options     |        | (in years)       |  | Exercise Price   |     | Options   |  | Exercise Price  
|                |  |             |        |                  |  |                  |     |           |  |                 
|$13.00-$14.00   |  |             | 5,000  |                  |  |                  | 9.8 |           |  | $                | 13.00 |  |  |  |  |  |  |  |  | 
|$14.01-$15.00   |  |             | 50,000 |                  |  |                  | 9.6 |           |  | $                | 15.00 |  |  |  |  |  |  |  |  | 
|                |  |             |        |                  |  |                  |     |           |  |                  |       |  |  |  |   |  |  |  |   | 
|$13.00-$15.00   |  |             | 55,000 |                  |  |                  |     |           |  |                  |       |  |  |  |  |  |  |  |   | 
|                |  |             |        |                  |  |                  |     |           |  |                  |       |  |  |  |   |  |  |  |   | 

The weighted-average grant-date fair value of
options granted during the period April 26, 2003 through
December 31, 2003 was $11 thousand.

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

The fair value of the options granted was
estimated on the date of the grant using the Black-Scholes
option-pricing model with the following weighted-average
assumptions: risk-free rate of 4.3 percent; dividend yield
of 13.2 percent; expected life of 10 years; and
volatility of 21.0 percent.

Total stock-based employee compensation expense
for the period from April 26, 2003 through
December 31, 2003 was $3 thousand.



|         |                         
|-------- | ------------------------
|Note 7  | The Management Agreement

The Company has entered into a Management
Agreement with the Manager that provides, among other things,
that the Company will pay to the Manager, in exchange for
investment management and certain administrative services,
certain fees and reimbursements, summarized as follows:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a base management fee equal to a percentage of
    average net worth during each fiscal year as defined in the
    Management Agreement (1% of the first $300 million plus
    0.8% of the amount in excess of $300 million);                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| |  | incentive compensation based on the excess of a
    tiered percentage (as defined in the Management
    Agreement as the weighted-average of the following rates based
    upon average net invested assets: (1) 20% for the first
    $400 million of average net invested assets; and
    (2) 10% for the average net invested assets in excess of
    $400 million) of the difference between the Companys
    net income (defined in the Management Agreement as taxable
    income before incentive compensation, net operating losses from
    prior periods, and items permitted by the Internal Revenue Code
    when calculating taxable income for a REIT) and the
    threshold return (the amount of net income for the
    period that would produce an annualized return on equity,
    calculated by dividing the net income, as defined in the
    Management Agreement, by the average net invested assets, as
    defined in the Management Agreement, equal to the 10-year
    U.S. Treasury rate for the period plus 2.0%) for the fiscal
    period; and
|
| |  | out-of-pocket expenses and certain other costs
    incurred by the Manager and related directly to the Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

The base management fee and incentive
compensation will be paid quarterly and are subject to
adjustment at the end of each fiscal year based on annual
results. One-half of the incentive compensation will be paid to
the Manager in cash and one-half will be paid in the form of a
restricted stock award under the Companys 2003 Outside
Advisors Stock Incentive Plan. The number of shares issued is
based on (a) one-half of the total incentive compensation
for the period, divided by (b) the average of the closing
prices of the common stock over the 30 day period ending
three days prior to the grant date, less a fair market value
discount determined by the Companys Board of Directors.
These shares are restricted shares for varying
periods of time, and are forfeitable if the Manager ceases to
perform management services for the Company before the end of
the restriction periods. The Companys restrictions lapse
and full rights of ownership vest for one-third of the shares on
the first anniversary of the end of the period in which the
incentive compensation is calculated, for one-third of the
shares on the second anniversary and for the last one-third of
the shares on the third anniversary. Vesting is predicated on
the continuing involvement of the Manager in providing services
to the Company.

From and after June 11, 2004, the Company is
entitled to terminate the Management Agreement without cause
provided that the Company gives the Manager 60 days
prior written notice and pays a termination fee and other unpaid
costs and expenses reimbursable to the Manager. If the
Companys

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

terminates the Management Agreement without
cause, the Company is required to pay the Manager a termination
fee as follows:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | If the Company terminates the Management
    Agreement without cause in connection with a decision to manage
    its portfolio internally, rather than by an external manager,
    the amount of the termination fee shall be equal to the amount
    of the highest annual base fee and the highest annual incentive
    compensation, for a particular year, earned by the Manager
    during any of the three years (or on an annualized basis if a
    lesser period) preceding the effective date of the termination,
    plus accelerated vesting on the equity component of all
    incentive compensation.
|
| |  | If the Company terminates the Management
    Agreement without cause for any other reason, the amount of the
    termination fee shall be equal to two times the amount of the
    highest annual base fee and the highest annual incentive
    compensation, for a particular year, earned by the Manager
    during any of the three years (or on an annualized basis if a
    lesser period) preceding the effective date of the termination,
    plus all deferred payments, including accelerated vesting on the
    equity component of all incentive compensation.                                         

The Company is also entitled to terminate the
Management Agreement with cause, in which case the Company is
only obligated to reimburse unpaid costs and expenses.

The Management Agreement contains certain
provisions requiring the Company to indemnify the Manager for
costs (e.g., legal costs) the Manager could potentially incur in
fulfilling its duties prescribed in the agreement or in other
agreements related to the Companys activities. The
indemnification provisions do not apply under all circumstances
(e.g., if the Manager is grossly negligent, acted with reckless
disregard or engaged in willful misconduct or active fraud). The
provisions contain no limitation on maximum future payments. The
Company has evaluated the impact of these guarantees on its
financial statements and determined that it is immaterial.

The base management fee for the period from
April 26, 2003 through December 31, 2003 was $901
thousand.

Incentive compensation is earned by the Manager
when REIT taxable net income (before deducting incentive
compensation, net operating losses and certain other items)
relative to the average net invested assets for the period, as
defined in the Management Agreement, exceeds the threshold
return taxable income that would have produced an
annualized return on equity equal to the sum of the 10-year
U.S. Treasury rate plus 2.0% for the same period. REIT
taxable net income (before deducting incentive compensation, net
operating losses and certain other items) for the period from
April 26, 2003 through December 31, 2003 was
$11.7 million and was greater than the threshold
return taxable income of $5.6 million for the same
period. Incentive compensation earned by the Manager during the
period from April 26, 2003 through December 31, 2003
was $1.2 million, of which $613 thousand was waived by the
Manager for the quarter ended September 30, 2003. Incentive
compensation is paid by the Company one-half in cash and
one-half in restricted stock.

Because of the timing of the Companys
initial investment of portfolio assets (investment activities
began on June 11, 2003, the first security purchase settled
on June 16, 2003, and $407.8 million of securities had
yet to settle as of June 30, 2003), interest income for the
period from April 26, 2003 through June 30, 2003 was
substantially lower than would be expected for a typical full
period, both in an absolute sense and also relative to the
average net invested assets for the period. However, for
incentive compensation purposes the calculation for
threshold return net income is based on average net
invested assets for the period with no adjustments made to
account for such timing differences. As a result, REIT taxable
net income (before deducting incentive compensation, net
operating losses and certain other items), for the period from
April 26, 2003 through June 30, 2003, was $298
thousand and was less than

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

the threshold return net income of
$426 thousand and, therefore, no incentive fee was earned by the
Manager or paid by the Company for that period.

The Company did not pay incentive compensation to
the Manager for the quarter ended September 30, 2003.
Although the Manager was entitled to receive incentive
compensation under the Management Agreement for the quarter
ended September 30, 2003, because of the net loss reported
by the Company for the period, the Manager voluntarily waived,
on a one-time basis, its right to incentive compensation for the
period due to the net loss reported during that same period.
Since the Manager waived its right to its incentive compensation
for the period ended September 30, 2003, the waived
incentive fee of $613 thousand was expensed and accounted for as
a capital contribution as of September 30, 2003.

For the quarter ended December 31, 2003,
total incentive fees for the Manager were $606 thousand,
one-half payable in cash and one-half payable in the form of the
Companys common stock as described above. The cash portion
of the incentive fee of $303 thousand for the quarter ended
December 31, 2003 was expensed in that period. In
accordance with SFAS No. 123, and related
interpretations, and EITF 96-18, 15.2% of the restricted
stock portion of the incentive fees, or $46 thousand, was
expensed in the quarter ended December 31, 2003. Included
in other assets at December 31, 2003 is $257 thousand of
deferred compensation which will be reclassified to
stockholders equity after the restricted stock is issued
and will be expensed over the three-year vesting period of the
restricted stock.

The remaining incentive fee for the quarter ended
December 31, 2003 of $30 thousand was earned by the
Companys Chief Financial Officer, in accordance with the
terms of his employment agreement. This portion of the incentive
fee is also payable one-half in cash and one-half in the form of
a restricted stock award under the Companys 2003 Stock
Incentive Plan. The shares are payable and vest over the same
vesting schedule as the stock issued to the Manager. The cash
portion of the incentive fee of $15 thousand for the quarter
ended December 31, 2003 was expensed in that period. In
accordance with SFAS No. 123, and related interpretations,
and EITF 96-18, 15.2% of the restricted stock portion of the
incentive fees, or $2 thousand, was expensed in the quarter
ended December 31, 2003. Included in other assets at
December 31, 2003 is $13 thousand of deferred compensation
which will be reclassified to stockholders equity after
the restricted stock is issued and will be expensed over the
three-year vesting period of the restricted stock. No incentive
compensation was earned or paid to the Chief Financial Officer
for the period from April 26, 2003 to September 30,
2003.

Note 8  Related Party
Transactions

At December 31, 2003, the Company was
indebted to the Manager for base management fees of
$418 thousand, incentive fees of $606 thousand and
reimbursement of expenses of $16 thousand. At December 31,
2003, the Company was indebted to the Companys Chief
Financial Officer for incentive fees of $30 thousand and to
officers and employees of the Company for expense reimbursement
of $18 thousand. These amounts are included in management
fee payable, incentive fee payable and other related party
liabilities.

The Managers financial relationship with
the Company is governed by the Management Agreement. Under the
Management Agreement, the Manager shall be responsible for all
expenses of the personnel employed by the Manager, and all
facilities and overhead expenses of the Manager required for the
day to day operations of the Company, and the expenses of a
sub-manager, if any. The Company shall reimburse the Manager for
its pro-rata portion of facilities and overhead expenses to the
extent that the Companys employees (who are not also
employed by the Manager) use such facilities or incur such
expenses pursuant to a cost-sharing agreement entered into
between the Company and the Manager. As of December 31,
2003, there were no expenses payable to the Manager pursuant to
the cost-sharing agreement. During the period April 26,
2003 through December 31, 2003, the Company paid the Manager

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

$6 thousand pursuant to the cost-sharing
agreement. The Company shall pay all other expenses on behalf of
the Company, and shall reimburse the Manager for all direct
expenses incurred on the Companys behalf that are not the
Managers specific responsibility as defined in the
Management Agreement.

Note 9  Fair Value of Financial
Instruments

SFAS No. 107, Disclosure About Fair
Value of Financial Instruments, requires disclosure of the
fair value of financial instruments for which it is practicable
to estimate that value. The fair value of mortgage-backed
securities available-for-sale and futures contracts is equal to
their carrying value presented in the balance sheet. The fair
value of cash and cash equivalents, interest receivable,
repurchase agreements, unsettled security purchases, note
payable, and accrued interest expense, approximates cost as of
December 31, 2003 due to the short-term nature of these
instruments.

Note 10  Accumulated Other
Comprehensive Loss

The following is a summary of the components of
accumulated other comprehensive loss as of December 31,
2003:

|                         |  |                            |         |                          |  |                   |      |   |  |   |         |  
|------------------------ |  | -------------------------- | ------- | ------------------------ |  | ----------------- | ---- | - |  | - | ------- | -
|                         |  | Net Unrealized Losses on   |         |                          |  | Accumulated Other
|                         |  | Mortgage-backed Securities |         | Net Unrealized Losses on |  | Comprehensive    
|                         |  | Available-for-Sale         |         | Cash Flow Hedges         |  | Loss             
|                         |  |                            |         |                          |  |                  
|                         |  |                           
|                         |  | (In thousands)            
|Beginning Balance        |  | $                          |        |                          |  | $                 |     |   |  | $ |        |  
|Change during the period |  |                            | (26,353 | )                        |  |                   | (157 | ) |  |   | (26,510 | )
|                         |  |                            |         |                          |  |                   |      |   |  |   |         |  
|Ending Balance           |  | $                          | (26,353 | )                        |  | $                 | (157 | ) |  | $ | (26,510 | )
|                         |  |                            |         |                          |  |                   |      |   |  |   |         |  

Note 11  Interest Rate
Risk

The Companys primary component of market
risk is interest rate risk. The Company is subject to interest
rate risk in connection with its investments in fixed-rate,
adjustable-rate and hybrid adjustable-rate mortgage-backed
securities, its related debt obligations, which are generally
repurchase agreements of limited duration that are periodically
refinanced at current market rates, and its derivative
contracts. At December 31, 2003, 88.9% of the
Companys securities portfolio were hybrid adjustable-rate
mortgage-backed securities, 8.6% of the Companys
securities were adjustable-rate mortgage-backed securities and
there were no fixed-rate mortgage-backed securities.

The Companys strategy includes funding its
investments in long-term, fixed-rate and hybrid adjustable-rate
mortgage-backed securities with short-term borrowings under
repurchase agreements. During periods of rising interest rates,
the borrowing costs associated with those fixed-rate and
hybrid-adjustable rate mortgage-backed securities tend to
increase while the income earned on such fixed-rate and hybrid
adjustable-rate mortgage-backed securities (during the
fixed-rate component of such securities) may remain
substantially unchanged. This results in a narrowing of the net
interest spread between the related assets and borrowings and
may even result in losses.

Among other strategies, the Company may use
Eurodollar futures contracts and interest rate swaps to manage
interest rate risk and prepayment risk. The effectiveness of any
derivative transactions will depend significantly upon whether
the Company correctly quantifies the interest rate or prepayment
risks being hedged, execution of and ongoing monitoring of the
Companys hedging activities, and the treatment of such
hedging activities for accounting purposes. In the case of the
Eurodollar futures contracts the Company had outstanding at
December 31, 2003, and any future efforts to hedge the
effects of interest rate changes on liability costs, if
management enters into hedging instruments that have higher
interest rates imbedded in them as a result of the forward yield
curve, and at the end of the term of these hedging

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

instruments the spot market interest rates for
the liabilities that are hedged are actually lower, then the
Company will have locked in higher interest rates for its
liabilities than would be available in the spot market at the
time. This could result in a narrowing of the Companys net
interest margin or result in losses.

Prepayments are the full or partial repayment of
principal prior to the original term to maturity of a mortgage
loan and typically occur due to refinancing of mortgage loans.
Prepayment rates for existing mortgage-backed securities
generally increase when prevailing interest rates fall below the
market rate existing when the underlying mortgages were
originated. In addition, prepayment rates on adjustable-rate and
hybrid adjustable-rate mortgage-backed securities generally
increase when the difference between long-term and short-term
interest rates declines or becomes negative.

The Company intends to fund a substantial portion
of its acquisitions of adjustable-rate and hybrid
adjustable-rate mortgage-backed securities with borrowings that
have interest rates based on indices and repricing terms similar
to, but of somewhat shorter maturities than, the interest rate
indices and repricing terms of the mortgage-backed securities.
Thus, the Company anticipates that in most cases the interest
rate indices and repricing terms of its mortgage assets and its
funding sources will not be identical, thereby creating an
interest rate mismatch between assets and liabilities.
Therefore, the Companys cost of funds would likely rise or
fall more quickly than would the Companys earnings rate on
assets. During periods of changing interest rates, such interest
rate mismatches could negatively impact the Companys
financial condition, cash flows and results of operations. To
mitigate interest rate mismatches, the Company may utilize
hedging strategies discussed above and in Note 12.

Note 12  Derivative Instruments and
Hedging Activities

The Company seeks to manage its interest rate
risk exposure to protect the Companys repurchase agreement
liabilities against the effects of major interest rate changes.
Such interest rate risk may arise from the issuance and
forecasted rollover of short-term liabilities with fixed rate
cash flows or from liabilities with a contractual variable rate
based on LIBOR. Among other strategies, the Company may use
Eurodollar futures contracts and interest rate swaps to manage
this interest rate risk. Derivative instruments are carried at
fair value.

The following table is a summary of derivative
instruments held as of December 31, 2003:

|                                        |  |                |   |            |  |            |      |   |  |   |      |  
|--------------------------------------- |  | -------------- | - | ---------- |  | ---------- | ---- | - |  | - | ---- | -
|                                        |  | Unrealized     |   | Unrealized |  | Estimated 
|                                        |  | Gains          |   | Losses     |  | Fair Value
|                                        |  |                |   |            |  |           
|                                        |  |               
|                                        |  | (In thousands)
|Eurodollar futures contracts sold short |  | $              | 3 |            |  | $          | (160 | ) |  | $ | (157 | )
|                                        |  |                |   |            |  |            |      |   |  |   |      |  

Cash Flow
Hedging Strategies

Hedging instruments are designated as cash flow
hedges, as appropriate, based upon the specifically identified
exposure, which may be an individual item or a group of similar
items. The hedged transaction is the forecasted interest expense
on forecasted rollover/reissuance of repurchase agreements for a
specified future time period and the hedged risk is the
variability in those payments due to changes in the benchmark
rate. Hedging transactions are structured at inception so that
the notional amounts of the hedge are matched with an equal
amount of repurchase agreements forecasted to be outstanding in
that specified period for which the borrowing rate is not yet
fixed. Cash flow hedging strategies include the utilization of
Eurodollar futures contracts and interest rate swaps. Any
ineffectiveness which arises during the hedging relationship is
recognized in interest expense during the period in which it
arises. Prior to the end of the specified hedge time period the
effective portion of all contract gains and losses (whether
realized or unrealized) is recorded in other comprehensive
income or loss. Realized gains and losses are

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

reclassified into earnings as an adjustment to
interest expense during the specified hedge time period. Hedging
instruments under these strategies are deemed to be broadly
designated to the outstanding repurchase portfolio and the
forecasted rollover thereof. Such forecasted rollovers would
also include other types of borrowing arrangements that may
replace the repurchase funding during the identified hedge time
periods. At December 31, 2003, the maximum length of time
over which the Company is hedging its exposure is 12 months.

The Company may use Eurodollar futures contracts
to hedge the forecasted interest expense associated with the
benchmark rate on forecasted rollover/reissuance of repurchase
agreements for a specified future time period, which is defined
as the calendar quarter immediately following the contract
expiration date. Gains and losses on each contract are
associated with forecasted interest expense for the specified
future period.

The Company may use interest rate swaps to hedge
the forecasted interest expense associated with the benchmark
rate on forecasted rollover/reissuance of repurchase agreements
for the period defined by maturity of the interest rate swap.
Cash flows that occur each time the swap is repriced will be
associated with forecasted interest expense for a specified
future period, which is defined as the calendar period preceding
each repricing date with the same number of months as the
repricing frequency.

For the period from April 26, 2003 through
December 31, 2003, there was no gain or loss recognized in
interest expense due to ineffectiveness. Based upon the amounts
included in accumulated other comprehensive income at
December 31, 2003, the Company expects to recognize an
increase of $157 thousand in interest expense during 2004.
This amount could differ from amounts actually realized due to
changes in the benchmark rate between December 31, 2003 and
when the Eurodollar futures contracts held at December 31,
2003 expire, as well as the addition of other hedges subsequent
to December 31, 2003.

Note 13  Summary of Quarterly
Information (Unaudited)

The following is a presentation of the results of
operations for the period from April 26, 2003 through
June 30, 2003 and the quarters ended September 30,
2003 and December 31, 2003.

|                                                  |                     |                                 |           |               |  |              |            |       |  |   |            |       | 
|------------------------------------------------- | ------------------- | ------------------------------- | --------- | ------------- |  | ------------ | ---------- | ----- |  | - | ---------- | ----- | 
|                                                  |                     |                                 |           | For the       |  | For the     
|                                                  |                     | For the Period                  |           | Quarter       |  | Quarter     
|                                                  |                     | from April 26,                  |           | Ended         |  | Ended       
|                                                  |                     | 2003 through                    |           | September 30, |  | December 31,
|                                                  |                     | June 30, 2003                   |           | 2003          |  | 2003        
|                                                  |                     |                                 |           |               |  |             
|                                                  |                     |                                
|                                                  |                     | (In thousands, except share and
|                                                  |                     | per share amounts)             
|Interest income                                   |                     | $                               | 672       |               |  | $            | 10,777     |       |  | $ | 11,205     |      
|Interest expense                                  |                     |                                 | 164       |               |  |              | 4,327      |       |  |   | 4,518      |      
|                                                  |                     |                                 |           |               |  |              |            |       |  |   |            |      
|                                                  | Net interest income |                                 |           | 508           |  |              |            | 6,450 |  |   |            | 6,687 | 
|Losses on sales of mortgage-backed securities     |                     |                                 |          |               |  |              | (7,831     | )     |  |   |           |      
|Expenses                                          |                     |                                 | 371       |               |  |              | 1,399      |       |  |   | 1,283      |      
|                                                  |                     |                                 |           |               |  |              |            |       |  |   |            |      
|Net income (loss)                                 |                     | $                               | 137       |               |  | $            | (2,780     | )     |  | $ | 5,404      |      
|                                                  |                     |                                 |           |               |  |              |            |       |  |   |            |      
|Net income (loss) per share  basic               |                     | $                               | 0.04      |               |  | $            | (0.24      | )     |  | $ | 0.40       |      
|                                                  |                     |                                 |           |               |  |              |            |       |  |   |            |      
|Net income (loss) per share  diluted             |                     | $                               | 0.04      |               |  | $            | (0.24      | )     |  | $ | 0.40       |      
|                                                  |                     |                                 |           |               |  |              |            |       |  |   |            |      
|Weighted-average shares outstanding 
    basic   |                     |                                 | 3,393,394 |               |  |              | 11,704,000 |       |  |   | 13,414,000 |      
|                                                  |                     |                                 |           |               |  |              |            |       |  |   |            |      
|Weighted-average shares outstanding 
    diluted |                     |                                 | 3,393,394 |               |  |              | 11,704,000 |       |  |   | 13,414,260 |      
|                                                  |                     |                                 |           |               |  |              |            |       |  |   |            |      

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LUMINENT MORTGAGE CAPITAL, INC.


NOTES TO
FINANCIAL STATEMENTS  (Continued)

Note 14  Subsequent
Events

On January 28, 2004, the Company filed an
S-8 with the SEC to register up to 1,000,000 shares of the
Companys common stock, par value $0.001 per share, to
be issued or delivered pursuant to the Companys 2003 Stock
Incentive Plan.

On February 4, 2004, the Companys
Compensation Committee issued 25,651 shares of restricted
stock to the Companys Manager in relation to the incentive
fees earned by the Manager during the quarter ended
December 31, 2003. The Manager subsequently assigned the
restricted stock to employees of the Manager, some of whom are
also officers of the Company. On February 4, 2004, the
Companys Compensation Committee also issued
1,283 shares of restricted stock to the Companys
Chief Financial Officer under the 2003 Stock Incentive Plan in
relation to the incentive fees earned by the Chief Financial
Officer during the quarter ended December 31, 2003. On
February 4, 2004, the Compensation Committee also issued
212 shares of restricted stock under the 2003 Stock
Incentive Plan to the Companys Controller.

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INDEPENDENT AUDITORS REPORT

To the Board of Directors and Stockholders of

Luminent Mortgage
Capital, Inc.:


We have audited the accompanying balance sheet of
Luminent Mortgage Capital, Inc. (the Company) as of
December 31, 2003, and the related statements of
operations, stockholders equity and cash flows for the
period from April 26, 2003 (inception) to
December 31, 2003. These financial statements are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these financial
statements based on our audit.

We conducted our audit in accordance with
auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit
provides a reasonable basis for our opinion.

In our opinion, such financial statements present
fairly, in all material respects, the financial position of
Luminent Mortgage Capital, Inc. as of December 31, 2003,
and the results of its operations and its cash flows for the
period from April 26, 2003 (inception) to
December 31, 2003 in conformity with accounting principles
generally accepted in the United States of America.

/s/ DELOITTE & TOUCHE LLP

San Francisco, California

February 27, 2004


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|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

None.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

As of December 31, 2003, our principal
executive officer and our principal financial officer have
performed an evaluation of the effectiveness of our disclosure
controls and procedures (as defined in Rules 13a-14(c) and
15d-14(c) of the Securities Exchange Act of 1934, or Exchange
Act, and concluded that our disclosure controls and procedures
are effective to ensure that information required to be
disclosed by the issuer in the reports that it files or submits
under the Exchange Act is recorded, processed, summarized and
reported, within the time periods specified in the Securities
and Exchange Commission, or SEC, rules and forms. The officers
have also concluded that there were no significant changes in
our internal controls or in other factors that could
significantly affect these controls subsequent to the date of
their evaluation, including any corrections with regard to
significant deficiencies and material weaknesses. There have
been no significant changes in our internal controls or in other
factors which could significantly affect internal controls
subsequent to December 31, 2003.




PART III






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

Pursuant to General Instructions G(3) to
Form 10-K, the information required by this item is
incorporated by reference from such information contained in our
definitive Proxy Statement for our 2004 Annual Meeting of
Stockholders, to be filed with the Securities and Exchange
Commission pursuant to Regulation 14-A.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

Pursuant to General Instructions G(3) to
Form 10-K, the information required by this item is
incorporated by reference from such information contained in our
definitive Proxy Statement for our 2004 Annual Meeting of
Stockholders, to be filed with the Securities and Exchange
Commission pursuant to Regulation 14-A.






|         |                                                                                                       
|-------- | ------------------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management and Related Stockholder
    Matters

Pursuant to General Instructions G(3) to
Form 10-K, the information required by this item is
incorporated by reference from such information contained in our
definitive Proxy Statement for our 2004 Annual Meeting of
Stockholders, to be filed with the Securities and Exchange
Commission pursuant to Regulation 14-A.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

Pursuant to General Instructions G(3) to
Form 10-K, the information required by this item is
incorporated by reference from such information contained in our
definitive Proxy Statement for our 2004 Annual Meeting of
Stockholders, to be filed with the Securities and Exchange
Commission pursuant to Regulation 14-A.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accountant Fees and
    Services

Pursuant to General Instructions G(3) to
Form 10-K, the information required by this item is
incorporated by reference from such information contained in our
definitive Proxy Statement for our 2004 Annual Meeting of
Stockholders, to be filed with the Securities and Exchange
Commission pursuant to Regulation 14-A.

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PART IV






|         |                                                                     
|-------- | --------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules,
    and Reports on Form 8-K

(a)1. and
(a)2.     Documents filed as part of
this report:

1. and 2.

All financial statement schedules are omitted
because of the absence of conditions under which they are
required or because the required information is included in our
financial statements or notes thereto, included in Part II,
Item 8, of this Annual Report on Form 10-K.

(a)3.     Exhibits

The exhibits listed on the Exhibit Index
(following the Signatures section of this report) are included,
or incorporated by reference, in this annual report.

(b).     Reports on
Form 8-K

We filed a report on Form 8-K on
December 22, 2003, reporting under Item 5 thereof,
that on October 24, 2003, the Board of Directors of
Luminent Mortgage Capital, Inc., a Maryland corporation (the
Company), elected by resolution to become subject to
Section 3-804 of Subtitle 8 of Title 3 of the
Maryland General Corporation Law (the MGCL), all as
more particularly described in the Articles Supplementary filed
as Exhibit 3.1 to the Form 8-K, which were filed with
the State Department of Assessments and Taxation of Maryland on
December 22, 2003. Section 3-804 of the MGCL provides,
inter alia, that notwithstanding any provisions of the
Companys charter or bylaws to the contrary, (a) a
director may be removed only by a vote of not less than
two-thirds (2/3) of all of the votes entitled to be cast on the
matter, (b) the number of directors may be set only by the
Board of Directors and (c) all vacancies on the Board of
Directors may be filled only by a majority of the remaining
directors then in office.

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SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.



| |                                
| | -------------------------------
| | LUMINENT MORTGAGE CAPITAL, INC.
| | (Registrant)                   



| |     |                   
| | --- | ------------------
| | By: | /s/ GAIL P. SENECA

| |                              
| | -----------------------------
| |                              
| | Gail P. Seneca               
| | Chief Executive Officer      
| | (Principal Executive Officer)
|
| | Date: March 3, 2004          



| |     |                        
| | --- | -----------------------
| | By: | /s/ CHRISTOPHER J. ZYDA

| |                                                 
| | ------------------------------------------------
| |                                                 
| | Christopher J. Zyda                             
| | Chief Financial Officer                         
| | (Principal Financial and Accounting
    Officer)
|
| | Date: March 3, 2004                             

Pursuant to the requirements of the Securities
Act of 1934, this report has been signed by the following
persons in the capacities and on the dates indicated.

|                                           |  |                                                                                                         |  |               |  | 
|------------------------------------------ |  | ------------------------------------------------------------------------------------------------------- |  | ------------- |  | 
|                                           |  |                                                                                                         |  |              
|Signature                                  |  | Title                                                                                                   |  | Date         
|                                           |  |                                                                                                         |  |              
|                                          
|/s/ GAIL P. SENECAGail P. Seneca           |  | Chief Executive Officer and Chairman of the
    Board, Director (Principal Executive Officer)           |  | March 3, 2004
|                                          
|/s/ CHRISTOPHER J. ZYDAChristopher J. Zyda |  | Chief Executive Officer and Chairman Financial
    Officer (Principal Financial and Accounting Officer) |  | March 3, 2004
|                                          
|/s/ ALBERT J. GUTIERREZAlbert J. Gutierrez |  | President and Director                                                                                  |  | March 3, 2004
|                                          
|/s/ BRUCE A. MILLERBruce A. Miller         |  | Director                                                                                                |  | March 3, 2004
|                                          
|JOHN MCMAHAN*John McMahan                  |  | Director                                                                                                |  | March 3, 2004
|                                          
|/s/ ROBERT B. GOLDSTEINRobert B. Goldstein |  | Director                                                                                                |  | March 3, 2004
|                                          
|/s/ DONALD H. PUTNAMDonald H. Putnam       |  | Director                                                                                                |  | March 3, 2004

87



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|                                         |  |                                                  |  |               |  | 
|---------------------------------------- |  | ------------------------------------------------ |  | ------------- |  | 
|                                         |  |                                                  |  |              
|Signature                                |  | Title                                            |  | Date         
|                                         |  |                                                  |  |              
|                                        
|/s/ JOSEPH E. WHITTERSJoseph E. Whitters |  | Director                                         |  | March 3, 2004
|                                        
|*By:                                     |  | /s/ GAIL P. SENECAGail P. SenecaAttorney-In-Fact |  |               |  | 

88



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##### Table of Contents






EXHIBIT INDEX

Pursuant to Item 601(a)(2) of
Regulation S-K, this exhibit index immediately precedes the
exhibits.

The following exhibits are included, or
incorporated by reference, in this annual report on
Form 10-K for fiscal year 2003 (and are numbered in
accordance with Item 601 of Regulation S-K).

|        |    |             |  |                                                                                                                                                                                                                                                                                                            
|------- | -- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 3  | .1          |  | Articles of Amendment and Restatement(1)                                                                                                                                                                                                                                                                   
|        | 3  | .2          |  | Articles Supplementary(2)                                                                                                                                                                                                                                                                                  
|        | 3  | .3          |  | Amended and Restated Bylaws(1)                                                                                                                                                                                                                                                                             
|        | 3  | .4          |  | Second Amended and Restated Bylaws(1)                                                                                                                                                                                                                                                                      
|        | 4  | .1          |  | Form of Common Stock Certificate(1)                                                                                                                                                                                                                                                                        
|        | 4  | .2          |  | Registration Rights Agreement, dated as of
    June 11, 2003, by and between the Registrant and Friedman,
    Billings, Ramsey & Co., Inc. (for itself and for the
    benefit of the holders from time to time of registrable
    securities issued in the Registrants June 2003 private
    offering)(1)
|        | 10 | .1          |  | Management Agreement, dated as of June 11,
    2003, by and between the Registrant and Seneca Capital
    Management LLC (Seneca)(1)                                                                                                                                                                     
|        | 10 | .2          |  | Cost-Sharing Agreement, dated as of June 11,
    2003, by and between the Registrant and Seneca(1)                                                                                                                                                                                                         
|        | 10 | .3         |  | 2003 Stock Incentive Plan(1)                                                                                                                                                                                                                                                                               
|        | 10 | .4         |  | Form of Incentive Stock Option under the 2003
    Stock Incentive Plan(1)                                                                                                                                                                                                                                  
|        | 10 | .5         |  | Form of Non Qualified Stock Option under the 2003
    Stock Incentive Plan(1)                                                                                                                                                                                                                              
|        | 10 | .6         |  | 2003 Outside Advisors Stock Incentive Plan of the
    Registrant(1)                                                                                                                                                                                                                                        
|        | 10 | .7         |  | Form of Non Qualified Stock Option under the 2003
    Outside Advisors Stock Incentive Plan(1)                                                                                                                                                                                                             
|        | 10 | .8         |  | Form of Indemnity Agreement(1)                                                                                                                                                                                                                                                                             
|        | 10 | .9         |  | Employment Agreement dated as of August 4,
    2003 by and between the Registrant and Christopher J.
    Zyda(1)                                                                                                                                                                                           
|        | 10 | .10        |  | Form of Restricted Stock Award Agreement for
    Christopher J. Zyda(1)                                                                                                                                                                                                                                    
|        | 10 | .11        |  | Form of Restricted Stock Award Agreement for
    Seneca(3)                                                                                                                                                                                                                                                 
|        | 14 | .1          |  | Code of Business Conduct and Ethics(1)                                                                                                                                                                                                                                                                     
|        | 23 | .1*         |  | Consent of Deloitte & Touche LLP                                                                                                                                                                                                                                                                           
|        | 31 | .1*         |  | Certification of Gail P. Seneca, Chairman of
    the Board of Directors and Chief Executive Officer of the
    Registrant, pursuant to Rules 13a-14(a) and 15d-14(a), as
    adopted pursuant to section 302 of the Sarbanes-Oxley Act
    of 2002                                                         
|        | 31 | .2*         |  | Certification of Christopher J. Zyda, Chief
    Financial Officer of the Registrant, pursuant to
    Rules 13a-14(a) and 15d-14(a), as adopted pursuant to
    section 302 of the Sarbanes-Oxley Act of 2002                                                                                               
|        | 32 | .1*         |  | Certification of Gail P. Seneca, Chairman of
    the Board of Directors and Chief Executive Officer of the
    Registrant, pursuant to 18 U.S.C. section 1350, as
    adopted pursuant to section 906 of the Sarbanes-Oxley Act
    of 2002                                                                
|        | 32 | .2*         |  | Certification of Christopher J. Zyda, Chief
    Financial Officer of the Registrant, pursuant to 18 U.S.C.
    section 1350, as adopted pursuant to section 906 of
    the Sarbanes-Oxley Act of 2002                                                                                                      
|        | 99 | .1          |  | Charter of the Audit Committee of the Board of
    Directors(1)                                                                                                                                                                                                                                            
|        | 99 | .2          |  | Charter of the Compensation Committee of the
    Board of Directors(1)                                                                                                                                                                                                                                     
|        | 99 | .3          |  | Charter of the Governance and Nominating
    Committee of the Registrants Board of Directors(1)                                                                                                                                                                                                           



---



|    |                                                                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Incorporated by reference from our Registration
    Statement on Form S-11 (Registration No. 333-107984)
    which became effective under the Securities Act of 1933, as
    amended, on December 18, 2003.

89



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##### Table of Contents





|    |                                                                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | Incorporated by reference from our Form 8-K
    filed on December 23, 2003.                                                                                                                                
|   
|(3) | Incorporated by reference from our Registration
    Statement on Form S-11 (Registration No. 333-107981)
    which became effective under the Securities Act of 1933, as
    amended, on February 13, 2004.



| |   |                
| | - | ---------------
| | * | Filed herewith.



| |   |                                                        
| | - | -------------------------------------------------------
| |  | Denotes a management contract or compensatory
    plan.

90